In the last five years, every time the stock market weakened by a similar magnitude as we saw this October, there was notable junk bond credit-spread widening. Even if one goes back further in time and looks at all sell-offs in this bull market that started in March 2009, one would see that sell-offs in the stock market correlate pretty well with sell-offs in the junk bond market – but not in 2018.
There was very marginal widening of credit spreads this month, which is nothing like what happened in the 2015 and 2016 sell-offs and in years prior. In other words, the marginal widening in the past month does not qualify as spreads “blowing out,” as traders like to say. Even though I have never seen a definition of what “blowing out” is, it has to be much larger than a barely observable zig-zag on a chart.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
To me, this aggressive selling in the stock market without aggressive selling in the junk bond market says that the problem is not economic, at least not in the U.S. economy. So far, this sell-off in stocks is very similar to what we experienced in February, both in sharpness and magnitude, so I think it too shall pass.
It is my experience that junk bond spreads tend to widen before the stock market makes its high for the cycle. In 2007, the junk bond credit spread widening (not counting the mortgage market) began in June and the stock market made its peak in October. The mortgage market began to show problems more than six months before the selling spilled into the border junk bond market.
None of this type of foretelling action from bonds is happening at present.
To be fair, there are plenty of things that are problematic with many emerging economies, not the least of which is China, but typically externally-generated sell-offs in U.S. stocks tend to be transitory. The only thing that can cause a lasting bear market in the U.S. are problems within the U.S. economy, like recessions or major financial crises, none of which are in the cards at the moment.
Because 2008 is still fresh in investors’ memories, there is the tendency for investors to worry during every sell-off. Still, 2008 was a crash driven by a malfunctioning financial system, which is not an issue we have at present. In fact, there have been only three sell-offs of such magnitude in the past 100 years–2008, 1974, and 1929. Of those three sell-offs only 1929 and 2008 are similar, where 1974 was due to an oil price shock. At present, we do not have out of control oil prices or a malfunctioning financial system.
The 1987 Comparison
Since it is October and we did see a crash in 1987 in the very same month without having a recession, we have to consider that computers may have gone berserk and the same may happen again. I think the present sell-off is very similar to what we experienced in May 2010 when the stock market declined 10% intraday, or the sharp sell-offs in August 2015, January 2016, and February of this year. All these sell-offs were driven by algorithmic trading with other algos and not driven by an economic problem in the U.S.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
In 1987 the Fed had just begun to hike interest rates, but the dollar was quite weak (it is strong today). It very well may have been the Fed tightening that caused the 1987 crash and the present sell-off, as the Fed tightening is very different this time, as it involves the running off of bonds in ever larger amounts from its balance sheet. In other words, as Treasury and mortgage bonds mature from the Fed’s portfolio, the proceeds are not reinvested in new bonds, up to $50 billion per month, a $600 billion annual runoff rate.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
It cannot be understated that the problems in the stock market started to get more notable as the Fed balance sheet runoff rate began to accelerate in 2018. Winding up the Fed balance sheet was in effect suppressing volatility in the bond market and by definition in the stock market, so unwinding the balance sheet should in effect be the reverse – increasing volatility in financial markets.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Still, there is something that does not quite fit here. One would expect that with all this Fed balance sheet unwinding bond market volatility would rise in 2018. Precisely the opposite has happened. We hit an all-time low in Treasury bond yield volatility in September 2018, so the Fed must be doing a really good job in unwinding its balance sheet, as neither credit spreads have risen nor has bond market volatility.
If I had to make a judgement call, I would say that the present sell-off in the stock market is not the beginning of a bear market. It is similar to what we saw in sell-offs in 2010, 2015, 2016, and in February of this year. It must also be noted that before the 2016 election, the stock market was down in four out of five weeks and the same thing seems to be happening this time. There is one more full week of trading before the midterm election, so I would say that this stock market sell-off is likely close to being over.
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