What, Me Worry?
With a flurry of executive orders, President Trump’s policies have dominated the headline news and incited protests. Many investors have expected the angst in the political world to carry over negatively into the financial markets. So far, this has not happened in a significant way.
Lenders to less than investment-grade companies (those rated BB or below) want to be compensated for taking the higher risk of default. These loans are called “junk debt” or “high-yield” and have a higher rate of interest than does U.S. treasuries and investment-grade corporate loans. How much more interest high-yield debt pays is based on the lenders’ perception of risk.
The interest rate spread between U.S. treasuries and high-yield loans is one way to measure the debt market’s view of risk. When spreads are rising, perceived risk is rising. When spreads are falling, perceived risk if falling.
The current spread between U.S. treasuries and high-yield loans is about 4% (measured by the BofA Merrill Lynch US High-Yield Options-Adjusted Spread). The chart below shows that when the spread rises (indicated in red boxes), the stock market tends to decline and when the spread tightens, the stock market usually appreciates.
Since the February 11, 2016 peak, spreads have fallen from about 9% to about 4%. On a year-over-year basis, spreads have declined from about 7.7%.
What, me worry? The high-yield debt market is showing essentially no rising concern over recent Trump actions.
Tying It All Together
The stock market itself is a powerful indicator. If stocks are rising, at a fundamental level it implies investors believe future earnings are growing and/or the environment is becoming less risky. The formula for stock values looks like this:
Relative to expectations about future earnings and the risk premium, the risk-free interest rate plays a minor role in determining stock values as it changes more slowly and is a small absolute number.
In the next chart, we show the values of each of the inputs in the stock value formula on a year-over-year basis. Bullish inputs are shown in green and bearish inputs are marked in red. We measure earnings with S&P 500 quarterly operating earnings. We use the high-yield spread as a proxy for the risk premium. When we look at what is happening with the rise in earnings and the decline in the risk premium, it is no wonder stocks have appreciated over the past year.
With high-yield spreads “tight” and earnings coming in above expectations, we see a continuation of bullish stock market trends in the intermediate term.
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This commentary and previous editions are available as PDFs:
2/3/2017: What, Me Worry
1/27/2017: Extraordinary Earnings Louder Than Trump
1/20/2017: It's Not All About Trump
1/13/2017: I Gotta Feeling
1/6/2017: Finally, A Case for International in Your Portfolio
12/30/2016: Predicting the Future -2017
12/23/2016: Bullish New Year
12/16/2016: All I Want For Christmas is Financial Independence
12/9/2016: Debt Trap
12/2/2016: Trade What Is, Not What You Think It Should Be – 2017 Outlook
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