How to Predict Stock Market Selloffs Using the Bond Market

October 30th, 2012 by

Credit Spread Chart

Video Transcript

Hi Folks David Waring here again from and today we are going to talk about how to predict future stock market movements using the bond market.

It is common knowledge among institutional investors, that while the average investor stays glued to the stock market, the “smart money” watches the bond market.  The bond market is much larger than the stock market and where the big boys play.  The bond market is also where interest rates are set, so you can think of the bond market as the dog  and the stock market as the tail that is getting wagged.  Because the smart money watches the bond market, it tends to move before the stock market, and can therefore act as an early warning system for stock market sell offs.

How does the bond market provide signals to stock investors?  Through something which is known as credit spreads.  Credit spreads are the extra yield that investors require for bonds which carry a greater credit risk than US Treasuries which are considered to be free of credit risk.  For example if the average investment grade corporate bond with 10 years until maturity is yielding yielding 5%, and the 10 year US Treasury is yielding 2%, then the investment grade credit spread would be 3%.

As you can see from this chart of the investment grade credit spread, credit spreads move over time.

When bond investors are comfortable and not very concerned about the economy and default rates, they will not require as large a premium over treasuries.  During these times credit spreads narrow, as the additional yield investors require on investment grade corporate bonds falls.  Conversely, when bond investors grow more concerned about the economy and default rates, they require a higher yield and credit spreads widen.  You can see this clearly during the lead up to and during the recent financial crisis, where credit spreads widened out dramatically.

What does this have to do with predicting the stock market?  The bond market has a better track record than the stock market at predicting problems in the economy.  Therefore, when the bond market gets concerned and credit spreads start to widen, it should be seen as a warning sign to stock investors that a stock market selloff may be coming in the near future as well.

One example of this is the top and dramatic sell off in the stock market during the recent financial crisis.  Here is a chart of the SPY ETF which is designed to track the price movement of the S&P 500 Index, and widely followed as a performance barometer of the overall US stock market.

As you can see the stock market topped and began its historic selloff in October 2007.

Now look at the chart of investment grade credit spread, zoomed in on 2007.  As you can see from the chart below, credit spreads widened out substantially starting in June of 2007, giving the astute investor an early warning sign of what was to come in the stock market.

Now I could have certainly cherry picked that piece of data, however I think you will find similar patterns with other stock market selloffs.  So you can see for yourself, I have included a link to the free credit spread chart from the Fed’s website below this video.

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