This Market's Getting Ready to Rock

With apologies to both Cool Hand Luke and Alan Greenspan, what we have here is failure to exuberate. The U.S. macroeconomic news has been getting stronger to the point at which no one should question whether the general recession is over, and yet the market has been struggling to get out of its own way.

I've said for years that when the technicals and the fundamentals diverge, you have to go with the technicals. Any windbag with a shoeshine and a business card can pontificate on what the market should be doing, but the technical structure of the market shows you what people actually are doing with their money.

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Don't Judge the Rally Yet

If we view price as a convergent search process for value, we must accept the premise that the underlying economic value of any asset must lead price. Price must then catch up to value. Generally, price overshoots value, but that's another story altogether.

While the meek are out there pretending they've inherited the earth, and the bombastic have been getting rallies thrown back in their face for the better (worse?) part of two years, market tension is accumulating. The unleashing of liquidity and resolution of affairs to the upside will come with greater risk acceptance. Let's check out some credit market indicators to see if this is about to happen.

Credit Spreads

We can compare the yields on various grades of corporate bonds with 10-year maturities, as provided by Standard & Poor's CreditWeek, to the yield on the benchmark 10-year Treasury note, to get a sense of investor sentiment. The two-week gap in September in the chart below is the result of the terrorist attacks.

This credit-spread measure is an excellent barometer of sentiment. As risk-seeking behavior diminishes, the spreads widen as investors demand greater expected return on their capital. A narrowing of credit spreads accompanies bull markets.

10-Year Corporate Bond Credit Spreads

Source: Bloomberg

The spreads on investment-grade bonds, or those rated BBB or higher, rose significantly compared with their March 2000 levels. However, these spreads have narrowed considerably since the end of September 2001, despite an upturn induced by accounting uncertainties. Bond investors are different from their equity-besotted cousins: While a stock can capitalize hope, all that a bond investor can hope for is to get paid back. The self-deluded need not apply.

The spread on the lowest grade bonds, single-B, narrowed between March 2000 and February 2002, but this category is buffeted by large movements for a small number of illiquid securities.

Index Spreads and Risk

A second measure of risk-seeking behavior can be found in the spread between the Nasdaq and the S&P 500. If we compare the spread between 10-year BB- corporates and Treasuries against this stock index ratio, the inverted and lagging relationship is quite visible. The explosive October 1998 to March 2000 rally in the Nasdaq occurred alongside a significant drop in credit spreads at the BB- level. Both markets were willing to fund risky ventures.

Once the party ended, this credit spread started to expand and continued to rise into the April 2001 spike bottom in stocks. The BB- spread plunged in October-November 2001, the time of a sharp Nasdaq rally, and then into the start of the year. Barring another catastrophe on the order of Enron or another external shock, this spread should narrow as the economy strengthens.

Even though technology and telecommunications are still mired in a slump, the conditions for investing in riskier equities appear to be in place. We're past the blood-in-the-streets point now, but investors in higher-yielding bonds, convertibles and small growth stocks should be rewarded.

Effect of Credit Spreads on Equity Risk-Seeking

Source: Bloomberg

Bank on It

Much has been made of bank credit being tight for lower-quality borrowers. This is to be expected. Bank lending is a lagging indicator of the economy. Well after business peaks, inventories are being financed, and backward-looking financial statements remain strong. And well after the economy rebounds, banks that have been burned by late payments and defaults are reluctant to extend credit. Bankers, unlike investors, don't get rewarded for being the first one to buy.

Can You Spot the Relationship? Bank Lending and Stock Prices

Source: Bloomberg

The lagging relationship can be seen quite clearly in a comparison of commercial and industrial lending to the S&P 500. Bank lending won't pick up for months, but when it does, the extension of credit on top of the Fed's loose credit will expand the money supply and trigger what could be an explosive rally by the end of the year.

Earnings? Hey, we've earned this one.

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Howard L. Simons is a senior vice president of product research at Nasdaq Liffe Markets, a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. The views expressed is this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to Howard Simons.

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