Stocks Lagging Credit Markets

A: WSJ blog Real Time Economics published a piece yesterday that was very timely with my post regarding the widening of corporate credit spreads. We both had the same idea as we look for any signs of normalcy or disruption in the credit markets. Most people look to stocks as a function of the economy's overall health. When stocks are up, things seem ok. When stocks are down, things seem to be slowing. It's quite amazing how the psychology of stock markets affect investors willingness to take risk. So who is right? The stock markets or the credit markets? Well, lets put that on the side burner now and discuss a more important point; stocks are lagging the credit markets!

According to Real Time Economics article, "Stocks Are Venus, Credit Is From Mars":

Who’s right: stocks or credit? Bianco thinks it’s credit: "The hallmark of the current environment is the equity market lags the credit markets. However, it is the equity market that sets the tone for everything else. So, no matter how bad the credit market gets, as long as the equity markets are holding together, no problems are perceived…. Last July we saw the same thing; the equity market was doing well but the credit markets were not. So as far as most people were concerned, there was no problem. In August when equities caught up to credit and turned sharply lower, it was called a crisis."

This is such a powerful force that I truly agree with. It's the reason I got so interested in learning what is going on UNDER the surface in an effort to profit later from stock price reactions to fundamental changes in the macro economy; in other words, it takes some time to be reflected in stocks! It's also the reason I discuss macro here on urbandigs, in an effort to discuss events that may ultimately affect us. So, I was curious to take the MARKIT ABX 'AAA' Index (which measures investor sentiment in the subprime mortgage markets) and plot it against a chart of the DOW since early August for a verification of stocks lagging nature to the credit markets. Sure enough, it's validated:

What an interesting thing when you compare two market forces such as equities and credit markets. Recall that the ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are commonly used by investors to speculate on or to hedge against the risk that the underling mortgage securities are not repaid as expected. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses from those investments.

So, as you can see on the above chart, the ABX index (BLACK LINE) declined rather sharply indicating a souring sentiment in the mortgage markets BEFORE stocks (BLUE LINE) followed with their decline. Now, there is something very important to note when making a relationship conclusion such as this; the effect of stimulus, rumors, and bailout plans on confidence for stocks.

Trust me, without the last 125 basis points of fed easing, Buffet's offer to re-insure the muni book, and bond insurer bailout talk we would probably be about 1,000 points LOWER on the Dow. Maybe more. There has been so much stimulus and bailout talk lately that has helped stocks recover and ease the pain that could have been much much worse. Which brings me to the credit markets.

There is little change here other than a positive effect on LIBOR due to targeted fed injections. The ABX Indices are still plunging, the CMBX Indices are cliff diving, and the CDX Index is showing a widening of corporate credit spreads. Clear signs that the credit markets are still dysfunctional. Now, will stocks lag in their reactions to the credit markets again OR will economic stimulus/bailouts save the day?

In the end, stocks overpower the credit markets in the eyes of public perception and is the preferred gauge as to how good or bad things are considered to be.

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