Credit Spreads - Time To Fade This Market

As I walk in this morning, I notice that SP E-Mini Futures are up 17 points, implying a 2% plus advance this morning. This is on the backs of European markets trying to get back into the black after a horrid start to 2009. This is after yesterdays non event Fed Meeting, and Obama's speech last night. There really was nothing special other then the usual quite brilliant and eloquent tone in our Presidents voice. Even though I have been harsh on Obama's tactics in handle the banking fiasco, I still think he will eventually do the inevitable but politically painful receiverships of at least 3 major banks.

As I have stated in the past, watching the credit markets and most importantly credit spreads in general is usually the best way to find a trend. I understand that these markets including the CDS Market have inherent drawbacks, like transparency and regulation, but the liquidity in these markets and the size of trades being executed dwarf whats going on in Equity Land. Also of importance, the credit markets act less on emotion and are more forward thinking then equities. Equities tend to be more reactionary.

From reading and observing during periods of insanity, I have come to an interesting observation on the credit to equity duality, which has helped me put the recent market rally in more of a educated and cohesive perspective.

The recent rally in the S&P 500 may appear to be topping out as it looks overdone (The market generally moves 6-9 months ahead of an assumed pick up in the economy) from a fundamental and technical viewpoint. But from a credit and options market perspective, looking back a few months, it was way overdue.

Why You May Ask? Was there a silver bullet? Yes and No.

From looking at various credit/options indicator indices and ratios, I was able to surmise after great anxiety the following.

Firstly-

When I say SPX or the "Market"- I mean S&P 500
When I say Credit Markets - I am speaking of the SPX 5 year CDS Spread.
When I say Options Markets - I am speaking of Equity Implied Volatility.

Options/Credit Markets showed increased anxiety levels despite the fact that the SPX was moving sideways for the better part of 2007. I understand that the SPX hit new highs on 3 occasions in 2007, but credit markets were steadily getting more nervous even after the market hit new highs in mid October 2007. Credit Spreads widened vastly towards the end of 2007. Beginning in 2008, as we all know, the global markets started a drastic down turn, which also precipitated more extreme widening in Credit Spreads, even after the Fed lowered rates in late January 2008 to alleviate strains in the credit system. Even as the market regained some footing over the next few month, credit spreads continued to widen and finally exploded to the upside after the Bear Stearn's fiasco. Again the markets recovered some 15% after Bear was sold to JP Morgan, but what we saw was more severe deterioration in the credit markets as the CDS Market started to peculate. What we saw over the summer and into the fall after Labor Day were the double edged sword of spiraling credit spreads and an expansion of Option Prices to extremely dangerous levels. After Labor Day 2008, the dye was cast for much lower equity prices across the globe. So the assumption to be made was to watch what happens to credit spreads and options volatility in regards to equity prices. Many many equity investors were totally caught off guard, that is why Options Volatility gauged by the CBOE VIX nearly quadrupled, as it seemed the entire planet was going to cash at the same time. During this entire global de-leveraging, we saw serious degradation in CDS Credit Spreads and Options Implied Volatility. So what was happening was that equity markets were finally catching up and listening to the credit markets.

Towards the end of 2008 and into March 2009, credit & options markets eased, while equity sold off more sharply, and made fresh new lows. On March 9Th, the SPX closed 10% below its November 20Th lows, but equity options volatility had relaxed some 25%, and more importantly Credit CDS Spreads were relatively flat with November levels.

THIS WAS THE TELL THAT THE MARKET WAS DUE FOR A HUGE BOUNCE.

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 very short short-term.

As I have written in earlier posts, I believed that the Nasdaq would rally huge once the market stopped going down, I will take credit for that one, as the COMP is up roughly 10% this year, as the SPX is still down. But I will have to take a Mia Culpa on the banks, I didn't foresee the huge run up in the financials, that is my bad (Even though I still they are basically insolvent).

What I am seeing today:

As the equity markets “caught up” to credit & 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 once again. In stark contrast, as the markets have exploded to the upside, bond/credit 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. The VIX, which is the 30 day volatility gauge has screamed back down to levels we saw in August 2008. The equity markets have caught up with Credit and Option markets, and recently have surpassed them. For example The Financials (PHLX BANKING) as a group have outperformed the SPX by a factor of 3x, yet CDS Spreads have improved only so slightly. When looking at Options Implied Volatility, we have started to see investors pricing in more risk going forward.

Net...Net...The financials as a group were extremely heavily shorted and oversold, and a serious snap back rally ensued, but they are seriously overvalued with respect to their CDS moves. As the past two month's non stop rally has been predicated upon the Financials upside, the next leg down will also be driven by that sector, as equity metrics catch up with credit and options implied risk.

The banks have rallied in the face of investors concerns over their balance sheet risk, The SP Financials have rallied 3x the broader market, while the Financials 5 year CDS spreads have continued to widen way above October levels.

YTD, Financials CDS spreads have actually widened 42% and options implied volatility is up 4%, as the market has rallied. The elevated risk priced into credit and options markets may foreshadow some major weakness in the financials, which will hit the broader markets in general. The credit market has become increasingly nervous about the potential for losses at BOFA, C, WFC, and JP, even after these banks have taken TARP money. Most of the people on the credit side of the market I think are becoming less favorable with regards to the government and their actions.

Its not surprising to see the markets rally even today, they are moving in the face of all this data that is so negative with regards to the banks and general economy. But what I am seeing is a major dislocation of credit fundamentals to equity fundamentals. At some point, the credit fundamentals will catch up stocks. Until then, maybe today, tomorrow, next week, the technicals are in charge, but beware.