Submitted by Erico Matias Tavares of Sinclair & Co. [9] [9]
Credit Giving Equities a Red Flag
With US equity markets trading in the vicinity of all-time highs, by definition you could have purchased the major indices at any point since the bottom in March 2009 and you would be in the money.
Extrapolating this strength into the future, longer term investors (those with a holding period measured in months) might be tempted to continue buying at these levels. Is this a wise strategy right now?
Nobody has a crystal ball so we are dealing with probabilities here. Looking at other asset classes can provide some clues of where we are in the current market cycle – in other words, establishing a near-term bullish or bearish bias, hoping to improve these probabilities in our favor.
The S&P/LSTA Leveraged Loan 100 Index mirrors the market-value-weighted performance of the 100 largest institutional leveraged loans based upon actual market weightings, spreads and interest payments. These are loans provided to companies that already have considerable amounts of debt in their balance sheets, therefore carrying a higher risk of default.
This index can thus provide a good sense of both liquidity and risk appetite in the credit markets. If lenders are feeling sanguine about the prospects of the economy, they will extend more leveraged loans at amenable rates. Borrowers in turn will use these funds to buy other companies, build out their businesses and/or pay back their shareholders. If the index is going higher it is “risk on” in the markets, which should be constructive for equities.
Weekly S&P500 Index (LHS) and S&P/LSTA Leveraged Loan 100 Index (RHS): Sep 09 – Jan 15
Source: S&P, The Loan Syndications and Trading Association.
And we can see this relationship at work in the graph above. The leveraged loans index has for the most part been a leading indicator for equities since the start of this bull run (it even bottomed in late 2008, a few weeks beforehand). The yellow shaded areas represent equity retracements greater than 8% from the prior high. Leveraged loans typically resume the uptrend quicker or have shallow corrections, providing in each case a bullish signal for equities.
Let’s focus on what happened in the lead up to the summer of 2011, right before the markets cratered on the back of everything that was going on in Europe and the downgrade of the US' credit rating by S&P. The leveraged loans index peaked at the start of the year and traded sideways up until that eventful August. This was a sign that something was not right in the credit markets; and equities pretty much followed the same pattern.
If we fast forward to today, we can see that the leveraged loans index peaked in July 2014, indicated by the red line in the graph, and has noticeably declined since; at the same time equities continued to move higher, a divergence which is a novelty in this bull market. Is this telling us something?
We believe so - it is a red flag for equities.
OK, loans are loans, equities are equities. After all, with no juicy yields available in other asset classes, equities are the only game in town right? And we do not have a large enough dataset to have a high degree of statistical confidence in this relationship, as the leveraged loans index is only available from early 2008. So it is possible that equities may continue moving higher from here.
But let’s also look at the breadth of the equities market, which can be used to confirm the strength of recent moves. More stocks advancing in relation to those declining is a bullish sign; meaning, there is a broad participation of stocks, a sign of liquidity and healthy investor appetite. The reverse also applies to spot areas of weakness, particularly when equities move higher without the confirmation of breadth.
The advance-decline ("AD") line is generally used as a measure of market breadth. It is calculated by accumulating the differences between advancing and declining issues over time [Note: we use the weekly closings of all stocks in the S&P500 and the NASDAQ to calculate the AD line, thus providing a broader representation.]
Weekly S&P500 Index (LHS) and the Advance-Decline Line (RHS): Sep 09 – Jan 15
Source: Wall Street Journal.
Notice in the graph how the AD line just jumped out of the gate much stronger than the equity index at the end of the bear market. This was a very bullish signal. And it has pretty much remained a leader - until recently.
Here’s one thing that is really intriguing: the AD line peaked a week before the leveraged loans index back in July (again, shown by the red line). Not long after, we witnessed the greatest pullback in equities for many months. The market’s advance since then has been supported by a smaller number of stocks, which is not indicative of strength.
Therefore, we have the leveraged loans index and the AD line basically telling us the same thing.
What does this all mean? Again, we are dealing with probabilities, but these divergences suggest caution for equity investors. If you are in the market it may be a good time to tighten your stops; otherwise you may wish to wait for everything to be in sync before jumping in.
After all, you do not want to be going up the equities creek without a good credit paddle.


