11.17.2021: The post-lockdown economy is on fire, thanks to a combination of pent-up demand and unprecedented government stimulus. The US economy expanded nearly 5 per cent for the 12 months ended in September; that’s after more than 12 per cent year-over-year growth in Q2. Retail sales, a barometer of household spending, grew 1.7 per cent in September, the most in seven months, according to the US Department of Commerce.
Equity markets, taking their cues from the economy, have surged. The S&P 500 is more than 25 per cent higher this year on the back of 40 per cent year-over-year Q3 earnings growth. At an estimated 22.5x forward earnings, the S&P 500 is situated in the top decile of its historical valuation range – suggesting that anyone who’s bullish on the market can’t fall back on the “market is cheap” argument.
Liquidity, the availability of money to borrow, spend and invest, is one of the most important factors driving the economy and markets today. Between fiscal spending and low borrowing costs, the world is awash in money. M2 – the total of cash, checking accounts and other near-term cash – has mushroomed by over 12 per cent over the last year. Money market balances currently total $4.5 trillion, representing about one quarter of GDP, and is helping to fuel spending, investing and ultimately, inflation.
Monitoring credit conditions, the primary factor propelling liquidity, is critical to navigating today’s equity markets. At roughly $40 trillion, domestic bond markets are about double the value of America’s stock markets, with institutional investors driving market behavior. Any cracks in credit will appear in bonds long before problems surface in stocks. Credit began drying up in Q4/07, nearly a year before the financial crisis pummeled the equity market.
Credit conditions are a valuable barometer for managing market risk. Simply put, you want to stay invested when credit conditions are favorable and reduce risk when credit conditions turn negative. The yield premium lenders require to extend credit to lower-quality borrowers is a great, real-time tool to gauge credit conditions. A low yield premium implies favorable credit conditions, reflecting lenders’ comfort with lending. A sudden rise in the yield premium suggests lenders anticipate trouble and require higher compensation.
Cresset’s credit conditions model defines “favorable conditions” as when the yield premium, or spread, is trading below 90 per cent of its 200-day moving average and “negative conditions” as when the spread is trading above 110 per cent of its 200-day moving average. Since 1998, holding the S&P 500 during favorable credit conditions and shifting to cash when credit conditions turn negative would have outpaced the S&P 500 by over 130 percentage points. What are our credit condition metrics telling us now? Hold the S&P. We will continue to monitor credit conditions, on the lookout for our next opportunity to reduce equity market risk and declare victory on this bull market.