Correlating Credit Spreads and Equity Prices

Includes: DIA, QQQ, SPY
by: Jim Delaney

On March 9th of this year investment grade spreads on the CDX index peaked at 262bs and the high yield index peaked at 1925bps. The S&P had its lowest close on this very same day at 676.53.

For all intents and purposes, that still holds as the closest thing we know as a true peek over the ledge into the abyss. That both credit spreads and equity prices hit their “ultimates” on the exact same date would, hopefully, dispel for many the anticipatory nature of CDS spread movement. It is, at its correlative high, a coincident indicator at best. But, as a coincident indicator, with a slight flair for anticipation, it has held its own through the thick and the thin on the roller coaster ride we have been on since August of 2007.

Since the days when the last market was called the “Wild West” and the participants “Cowboys”, it wasn’t because they were sitting around an “X” shaped trading desk with Michael Milken at its nexus on the western shore of these United States but more for the lawlessness with which it appeared that market conducted itself with.

The CDS market is still under that cloud but, given the true economic benefits it provides it will survive and prosper. Regardless of whatever Congress throws at it.

With all that said and knowing that the highest correlation between spreads and equity prices exists on the high yield end of the spectrum, and given that spreads; both high yield and investment grade have literally collapsed since the Ides of March, it is worth noting that some who are paid well to watch all things “Junk” have turned a bit cautious.

“There has been a huge rally in high yield [prices], with everyone repricing out of the depression scenario” Fred Hoff, manager of Fidelity’s High Income fund recently said. But “anyone with outsized expectations is likely to be disappointed “Jeff Tjornehoj countered when asked about the outlook from here. “There have been some fantastic returns, but those were historical high marks. It’s unlikely we’ll see those again.”

If then, we refer to Isaac Newton’s third law, which states: for every action there is an equal and opposite reaction; and take into account the wisdom of Mssrs. Hoff and Tjornehoj what can we expect from here?

If we refer to another noted scholar; a Leonardo, but not da Vinci, Fibonacci, high yield spreads could go back to 1269 or even 1433 without ruining the downtrend they began in March. Were this the case what would that imply for equity price you ask? Replete with the requisite admonitions; the 1/3rd and ½ retracements from the rally off of the March lows would put the S& P at 843 and 811 respectively.