As Zero Hedge has repeatedly pointed out in the past, the credit market is usually the best barometer of trends and perceptions, not least due to its liquidity (especially in CDS) and size which is multiples higher than the equity market, and thus much less susceptible to outright nudges here and there. A comprehensive report out of Goldman Sachs presents some interesting observations on the credit - equity relationship, which (whether due to correlation or causation) may put the recent rally in a more coherent perspective than its daily technically-driven fluctuations.
The S&P 500’s recent rally may appear overdone from a fundamental perspective, but from a credit and options perspective, it appears overdue. Credit and options have lagged in the recent rally and may foreshadow a stall in the S&P 500.[TD: not sure this accounts for forced short covering rallies].
Credit and options markets relaxed from December to early-March, while equity sold off sharply: On 9-March, the S&P 500 closed 10% below its 20-November lows, while equity options had eased 25% (6 month 25 delta put implied volatility) and credit spreads were flat (index weighted 5 year CDS spreads) over the same period. Flat credit spreads and lower equity options prices are evidence of reduced hedging demand in both markets, signaling increased comfort with current levels. In hindsight, this was a clear and extreme divergence and an opportunity to become more constructive on equities in the short-term.
As equities “caught up” to credit and options markets, risk in those markets did not continue to ease as meaningfully. No longer supported by credit and options market easing, the equity market seems set up to stall as fundamentals and financials sector stresses take center stage. In contrast to the recent rally, bond spreads remained wide, even wider than CDS would indicate, and longer-dated volatility, while down somewhat, continued to price in Depression Era levels of volatility.
We display moves of each of the three markets below: (1) S&P 500 equity index, (2) weighted average stock implied volatility and (3) weighted average 5 year CDS spread. This chart, as well as more complex regressions, suggests that equities have closed the gap and are only modestly undervalued relative to the moves in credit and options.
The chart below demonstrates just how much of an overvalued outlier financial stocks have become with respect to CDS moves. As the past month's non stop rally has been predicated upon financial company upside, the leg down will also be driven by that sector, as equity metrics catch up with credit implied risk.
We believe the Financials rally belies investor concern regarding capital adequacy, the stress test, and accelerations in credit problems. The S&P 500 Financials index is up 59% since the 9-March trough, almost triple the increase in the average S&P 500 stock. Financials 5 year CDS spreads remain near their wides, well above October levels, tightening only 19% recently. Year-to-date, Financials CDS spreads have actually widened 42% (5 year index weighted CDS spreads) and options implied volatility is up 4% (6 month 25 delta put implied volatility). The Equities have fallen by a more modest 22%.
While options prices on some Financials are down from their highs, the volatility market is clearly differentiating between banks that our analysts believe can repay the TARP and those that cannot. Implied volatility for the companies in our Financials team’s Disentanglement Basket (GSRHAGOV) is 30% off its highs and well below November levels. In contrast, options prices for companies less likely to repay TARP set new highs this year and only fallen modestly from those highs on average. The elevated risk priced into credit and options markets may foreshadow weakness and volatility in financials equities.
At various points in late 2008 and early 2009, credit spreads for banks who had received TARP funds were tighter than non-TARP financials, that gap has now closed (see chart below). The credit market appears increasingly nervous about the potential for losses at even the banks that have received TARP funds. Credit investors are likely reducing their expectations that government actions will be as favorable to bond holders as they assumed in the past.
All in all it is not surprising that even as equity markets rally on unfounded green shoot rumors and technical liquidity aberrations, credit is preparing for a contraction and is ignoring the equity "rally" less and less. At some point, the fundamentals will catch up stocks as will credit implied risk. Until then, the technicals are in charge and with liquidity marginalized, it is easy to see the market have significant spike on little to no volume for the foreseeable future.