A sluggish month in the stock market has equity investors worrying about what's next.
But those equity investors would feel so much better if they'd just spend a little time studying the credit markets. And with good reason: The bull market in credit that continues to rage in the face of this stock-market lethargy leads us to one simple conclusion.
Stock prices have to head higher.
Indeed, independent analyst Brian Reynolds tells us that if stocks were trading at the same level as credit, the Standard & Poor's 500 Index would already be at 1,350 – 22% above where it closed on Friday.
For those who argue that the market has already rallied a great deal, or too much, let me just note that the S&P 500 would have to rise by another 41% just to get back to the level of three years ago. The key thing that bulls have in their back pocket is that investors are still trying to get used to the idea that the sky hasn't fallen – and have not yet priced in the prospects for a 25% increase in S&P 500 profits that we are likely to see in 2010.
Credit Markets Call the Shots
No one else likes to talk about credit – or the credit markets – which is why we think it's so important to do so.
Issuance of corporate debt has been going on at spreads to U.S. Treasuries so low that they are making veteran credit guys blink in disbelief. Issuance surpassed the $9 billion per day mark in the first two days of last week.
Here's a stunner: Reynolds, the independent analyst, says that financial-company bonds have actually been leading the way – even though stock-market investors seemingly hate the group. A great example: Blackrock Inc. (NYSE: BLK) recently did a $3 billion deal that Reynolds says could have been twice the size given the "voracious demand of credit funds."
Normally you would expect this to push spreads wider. Instead, investment-grade spreads have been narrowing, and junk spreads have actually held onto the bulk of their spectacular narrowing last week.
The gold standard of a riskless asset is a U.S. Treasury bond. So let's say a U.S bond is trading at a 2% yield. If you can sell your corporate bond with a 5% yield, the market would say that the spread was the difference between 5% and 2% – or 3%.
However, in this particular case, each percentage point is made up of 100 "basis points," and spreads are usually expressed in these terms. In this case, the spread 3% would be expressed as "300 basis points."
As an issuer of debt, you would like to have your yield be as low as possible. The reason: That's the interest you have to pay once the debt has been issued. But lenders (i.e. bond buyers) want to be compensated as much as possible for the risk they are taking. When risk is perceived high, as it was last year at this time, spreads are wide. When risk is perceived to be lower, or bond buyers are just anxious to buy product, spreads become narrower.
What Reynolds is saying is this: Even though stock investors seem to think that the stocks of financial companies are something to be thrown overboard like confetti, bond buyers – who, by the way, everyone will tell you tend to be the smartest guys on Wall Street – are saying that the bonds of financial companies are valuable.
Funny huh? The greatest bond rally in history rumbles on, Reynolds says, and equity guys are acting as if it is not happening. He's been around the Street a few times, both as an equity and credit fund manager, and understands the two groups of investors very, very well.
He called the crisis on the way down in 2007 and 2008 in a brilliant, precise and energetic way. Now he's calling it on the way up in the same enlightening manner. Don't forget: If we were stocks trading at the same level as bonds, the S&P 500 would be more than 20% higher than it is today.
And I believe that Reynolds is correct.
One more little item before leaving debt. While equity investors have been treating the credit crisis in Dubai and Greece as if the sky were falling, credit investors have not even blinked an eye.
Lessons From History
Both are trading at one-year or all-time highs. As Reynolds tells us: "I find it almost comical how equity investors are worried about how these sovereign issues may end the credit bull market, but credit investors aren't."
At turning points like this one, it's the credit guys who will turn out to be correct – almost without fail. In 2007, the credit market fell apart way before the equity market. And this year, the credit market has advanced far ahead of the equity market.
Let's be clear on an important point: The assumption, belief and expectation is that the equity markets will catch up, not that credit markets will fall back.
That doesn't have to happen right away. In fact it can take months, or even years. But credit is pointing us higher, and that is where we are likely to go.
[Editor's Note: As the story above demonstrates, Money Morning Contributing Writer Jon Markman has a unique view on the markets. With uncertainty the watchword and volatility the norm in today's markets, profitable investments are harder than ever to find. It takes a seasoned guide to find those opportunities.
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