What Widening Investment Grade Spreads Are Saying About The Stock Market

The U.S. stock market remains stuck in a range.

 

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Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

 

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are walking blindly into the future.

Investment grade spreads are widening

Investment grade bond spreads have been rising since late-2017. In the past, investment grade spreads widened BEFORE equity bull markets topped.

 

Interestingly enough, the S&P 500 is still positive on a year-over-year basis despite the current correction.

Here’s what happened next to the S&P 500 when investment grade spreads widened by more than 0.49% over the past year while the S&P 500 was still positive.

 

Let’s narrow down the sample size to see the first case in 3 months.

 

You can see that the stock market’s forward returns start to deteriorate 6 months later.

Financial sector weakness

The financial sector has been hammered this year, possibly due to the flatness of the yield curve. Here’s the KBW Bank Index ($BKX)

 

Here’s what happened next to the S&P 500 when BKX fell more than -20% to a 1 year low, while the S&P was within 10% of a 1 year high.

*Data from 1993 – present

 

As you can see, there are really only 2 cases: 2000 and 2007. On average, the stock market was ok up until 6 months later, after which forward returns deteriorated significantly.

Failed rallies

Many of the stock market’s intraday rallies over the past week have failed, with the stock market falling in the later part of each day.

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Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our clear, quantitative trading models, such as the  more

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