“If the last hundred years of market cycles teaches anything, it's that one can't be a great equity investor without also being a solid credit analyst. Credit crunches and financing booms have killed and fueled bull markets. Analysis of the corporate credit markets today provides one fundamental reason for the stock market rally to continue. It's not enough by itself; however, it is a necessary element. Our aggregate credit default swap calculation of the riskiest "high-yield" companies in the USA tells us that the financing fuel is coming and in a big way. That's the "660 to 390" move that we're seeing in aggregate CDS.”
Since then, almost exactly 5 years ago, the S&P 500 has risen 72% or roughly 11% a year, and that includes the drop from all-time highs we’ve seen since late January. In that article, we highlighted the importance of financing availability for bull markets, and that remains very true today. With volatility reentering the market in 2018, there have been whispers, or even shouts of the possibility of a looming bear market, and most people argue valuations are too high (Shiller’s CAPE of 32x for example), or that the market has run too fast (with the S&P nearing 3,000, up over 4x since the depths of the recession), without considering the credit context in which the market run has occurred.
The credit default swap can be an invaluable tool for equity investors that is often overlooked. It allows the credit investor to trade away much of the risk associated with owning corporate debt, for a specific price. With a liquid market for credit default swaps, equity investors have a readily available metric for judging the cost of financing, and thereby the availability of financing to corporations that can continue to fuel a stock market rally.
When CDS rises, it of course points to higher costs of financing, but also signals unwillingness of banks and investors to finance and refinance company debt. This, coupled with analysis of the number of banks tightening lending standards (found in the Senior Loan Officer Opinion Survey or SLOOS) can help equity investors determine whether credit tightening is reaching a level indicative of a coming bear market, and recession. We track credit default swaps at an aggregate level for investment grade, cross-over, and high-yield credits over time to monitor these signals. Our aggregate high-yield credit default swap index reached well over 2,000 bps by the time the market collapsed into March 2009. As the SLOOS highlighted, the over 30% of banks were tightening credit by early 2008, a number that ballooned to 80% before the bottom.
However, what we have seen since 2011 is the exact opposite of late 2007, with improving aggregate CDS and loosening credit standards, pointing to improving credit market conditions required for a continued bull market. Today, we are seeing aggregate CDS levels that are nearly half those seen five years ago, and a fifth of high yield levels back in 2011, with continued easing of standards on bank loans.
As highlighted in the chart below, in late 2016, aggregate CDS for high-yield credits fell towards 200bps levels that have held through today, the lowest point since well before the recession, pointing towards the cheap credit that is required to continue fueling a bull market:
In addition, as the SLOOS highlights, the net percentage of banks tightening standards of lending has ranged around 0% since 2015, and is currently negative, highlighting that more banks have eased their credit standards for approving applications, mostly for C&I loans. This relaxing signals access to credit, and supports a growing economy and a bullish equity market thesis:
Although there is more to a bull market than just credit standards, accelerating fundamentals have not led to accelerating stock returns in the last several months, as investors are getting more skittish about the potential of a recession and a repeat of the crash that burned so many in 2008. However, these concerns are largely unfounded, as historic analysis shows that bear markets and recessions do not occur without credit destruction. Without a risk of major credit issues in the near-term, there remains reason to believe the longest bull market of recent memory can continue.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.