Does The Equity Market Have Legs?

After the recent bounce in stock prices, pundits and punters alike are wondering if there’s yet another upleg due for equities. The smart money says “yes.” Those in the know keep an eye on credit spreads, especially the yield premium of junk bonds over ten-year Treasuries. Changes in the spread often presage fluctuations in the stock market. Not everyone has access to junk bond pricing, but virtually anybody can pull up a quote on the ProShares Short High Yield ETF (NYSE Arca: SJB). The fund aims to provide unlevered inverse (-1x) exposure to the Markit iBoxx $ Liquid Yield Index. Wanna bet against junk bonds? Buy SJB.   

SJB’s price pretty much mirrors the high yield credit spread, rising and falling in lockstep. And, if you hadn’t noticed, both the spread and SJB have swooned lately. So much, in fact, that SJB broke below a key support level established last fall. That’s good news for equity investors. Just take a look at Chart 1. Notice an inverse relationship between SJB and the SPDR S&P 500 ETF (NYSE Arca: SPY)? Notice, too, how SJB prices move just a step ahead of SPY?

SJB reached new lows in the first week of February, tested resistance, then fell further this week. In response, the equity market capped that week at a record high. The question now is how far stocks can go from here. Another spread offers a clue.

The spread between SPY’s price and that of the iShares S&P 100 ETF (NYSE Arca: OEF) highlights stock investors’ bullishness. The stocks in OEF are the bluest of the S&P 500’s blue chips. The SPY price premium widens as investors embrace risk; the premium shrinks when investors pull in their horns and become more defensive.

To begin February, the SPY premium broke out of a congestion area to reach a new high above $117. And, from the looks of the spread’s track record (see Chart 2),  we seem to have enough gas to propel the premium to the $138 level.