The Bond Market Is Saying That SPY Can Keep Going Higher
The SPDR S&P 500 (SPY) is arguably the most-watched ETF in the market since it tracks the massively popular S&P 500 index. This ETF is now approaching the critical price level of $300 per share, and this move has massive implications going forward.
Source: Think or Swim
SPDR S&P 500 has failed in the area of $300-303 per share on several occasions over the past year. Besides, the economic slowdown and geopolitical instability are producing plenty of concerns among investors. In this context, investors are wondering if this will be another failed attempt to break above $303 per share or if SPDR S&P 500 can make a sustained move towards historical highs and beyond.
There is no way to know for sure what the market will do next, but we can watch some market indicators with a solid track record of performance to analyze the probabilities of different scenarios.
Global financial markets are deeply interconnected, and we can gain some valuable information about the stock market by analyzing the main developments in the bond market. As of the time of this writing, the bond market is sending a bullish signal for SPDR S&P 500.
Listening To The Bond Market
Bond investors are said to be more risk-averse than stock investors, and we can learn a lot about global risk appetite by watching the main developments in the bond market.
When bond investors are concerned about the possibility of a recession, they tend to gravitate towards the safety of Treasury bonds. Conversely, when risk appetite is rising in the bond market, investors generally go hunting for higher returns by investing in high yield bonds.
High yield credit spreads can be a key leading indicator for stocks. The chart below shows how SPDR S&P 500 has evolved over the past decades in blue, with the high yield credit spreads in orange. Shadowed areas signal recessions.
It is easy to see that the deepest bear markets for SPDR S&P 500 tend to come when credit spreads are surging. Big bear markets and recessions tend to come together, and credit spreads usually start rising before the recession is visible in the economic data.
(Click on image to enlarge)
Data by YCharts
In order to quantify the relationship between SPDR S&P 500 and global risk appetite as expressed by the bond market, we can rely on con the Credit Market Model. This is a quantitative system based on managing risk exposure in the stock market by watching the main trends in the bond market.
The strategy is based on a ratio that measures the relative performance of iShares iBoxx $ High Yield Corporate Bond (HYG) versus iShares 7-10 Year Treasury Bond ETF (IEF). When this ratio is rising, it means that high-yield bonds are outperforming Treasury bonds, so risk appetite is increasing and credit spreads are falling.
The chart shows how the ratio has evolved in recent months, with the 100 days moving average as a trend indicator in black. When the ratio is above the moving average, it means that risk appetite is increasing in the bond market, sending a bullish signal for stocks.
(Click on image to enlarge)
Source: ETF Replay
When the ratio is above the 100-day moving average, the system is invested in the SPDR S&P 500. Alternatively, when the ratio is in risk-off mode, the system buys the iShares 20+ Year Treasury Bond ETF (TLT) to protect the portfolio.
Since January 2008, the first full year in which all of the ETFs in the system are available for trading, the quantitative strategy gained 436.1% versus a cumulative gain of 159.9% for the SPDR S&P 500 in the same period.
(Click on image to enlarge)
Source: ETFreplay
(Click on image to enlarge)
Source: ETFreplay
The maximum drawdown, meaning the greatest percentage drop from the high, is 18.9% for the quantitative strategy versus 52.3% for buy and hold investors in SPDR S&P 500 over the same period.
The strategy has produced solid returns with moderate risk over the long term, but it's important to understand that future returns will depend on market conditions to a good degree.
In times when treasuries and high yield bonds are moving sideways, the strategy will probably produce many false signals. Besides, when there is a rapid reversal in risk appetite, it will take some time for the strategy to read the signals from the credit market and adjust the portfolio risk.
On the other hand, when there are well-defined trends in risk appetite in the bond market, either up or down, the quantitative strategy should be able to do a solid job at capturing these trends and benefiting from them.
The table below shows the performance metrics for the Credit Market Model versus a long position in SPY for different years. In a year such as 2008, when stocks crashed and bonds surged, the strategy gained 24.7% versus a big loss of -36.8% for SPY. Conversely, in a sideways year such as 2015 or 2019, the strategy can be expected to underperform.
(Click on image to enlarge)
Source: ETFreplay
Reading The Data
The Credit Market Model has been in a risk-off mode for quite some time in 2019. However, this is mostly because Treasury bonds have been surging, while credit spreads have remained under control. When this happens, the environment for stocks is quite benign. The big problem comes when Treasuries are surging and credit spreads are also sending a risk-off signal.
If we zoom into the relative performance of SPY and high yield spreads in the past year, we can see that, even in periods when SPY pulled back, high yield spreads have been making a series of lower highs. This can be interpreted as a positive signal from the credit markets.
(Click on image to enlarge)
Data by YCharts
More recently, with the pullback in Treasury bonds, the signal line in the Credit Market Model has officially flashed a risk-on signal, which has bullish implications for the stock market in general and for SPY, in particular.
(Click on image to enlarge)
Source: ETFReplay
Investing is always a matter of probabilities as opposed to certainties, so we need to weigh the evidence from different indicators in order to assess what the probabilities are for different scenarios.
The credit market is just one source of evidence among several sources that can be considered, but it has proven to be an effective indicator over time. Looking at the data, the bond market is sending a bullish signal for SPDR S&P 500 right now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: I wrote this article myself, and it expresses my ...
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