'Irrational Exuberance' At Play?

You can’t say we weren’t warned of the stock market’s vulnerability before the COVID-19 outbreak. Just look what was going on with credit spreads leading up to the February break. The chart below compares the performance of the SPDR S&P 500 Trust (NYSE Arca: SPYand the price ratio of the iShares iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYGover the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE Arca: LQD). HYG is a portfolio of mostly BB- and B-rated paper while LQD is loaded with bonds carrying A and BBB ratings.

The ratio is a simulacrum for credit spreads, reflecting the cost of money for less-than-prime borrowers.

Fluctuations in credit spreads—and, by extension, the HYG/LQD ratio—reflect shifts in the effective supply of funds.

Ordinarily, the ratio moves in sync with the equity market, so divergences are noteworthy. And, if sustained, also symptomatic. A rising ratio bespeaks tight spreads and prospects for a bullish market. Spreads widen as the ratio falls, indicating a rough patch ahead for stocks.

Recall the fall of 2018 when stocks sold off hard, bottoming just before Christmas. The HYG/LQD ratio declined as well but continued to sink further in the new year as stocks rallied to new highs.

(Click on image to enlarge)

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Notice how the ratio set up a wedge-shaped congestion area ahead of the February 2020 stock market break. As early as the autumn of 2019, credit spreads were flashing warning signals. Wedge patterns typically foreshadow significant, and often explosive, moves. And, indeed, what followed in 2020 was explosive: 34% of SPY’s market value was detonated.

But now SPY’s losses are being recovered as yet another congestion area—this one pointing definitively to the upside—has formed in the ratio’s trajectory. Where can the ratio—and SPY—go on a breakout?

Well, the ascending triangle pattern you see on the chart isn’t associated with the same kind of volatility than ensues a wedge breakout. In this case, just a 4% upside from Monday’s close seems likely.

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Disclosure: None.

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