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Watch market spreads to gauge a scary market - Nov. 10, 2011
FORTUNE -- With the economy wobbling, what's the best way to tell
whether the stock market is headed for a complete meltdown or poised for
a roaring rally? Simple: Watch the spreads. No, not the latest lines
from Vegas oddsmakers. Rather, experts point to three key metrics in the
credit markets that have historically given investors a good sense of
the risk environment ahead.
Start with the so-called TED spread,
which measures the difference between the rates on three-month U.S.
Treasury bills and the three-month London interbank offered rate, or
Libor (the rate at which banks borrow from one another). The wider it
is, the more skittish banks are about lending. Right now, the TED spread
is telling investors to "tread lightly in stocks," warns Gina Martin
Adams, an equity strategist at Wells Fargo Securities.
The
TED spread has more than doubled since Jan. 1 and now hovers around 40
basis points (100 basis points equals one percentage point). That's a
far cry from the 400-plus basis points reached during the 2008 financial
crisis, but it's still a troubling trend. Wells Fargo's Adams points
out that even as the S&P 500 (
SPX)
index was soaring more than 11% during early October, the TED spread
continued to widen. That kind of divergence is "usually a warning sign
worth noting," she says. "Credit markets have not confirmed the positive
tone of equities."
Another gap worth watching is the difference between the yields on
10-year U.S. government bonds
and high-yield (junk) bonds. It reflects the premium that investors
demand for taking on the extra risk of default, and it has widened
significantly of late. The spread between the Bank of America Merrill
Lynch U.S. High Yield Master II index and 10-year Treasuries hit 7.6
percentage points in late October, well above the historical average of
around six points. That indicates that bond investors are anticipating a
rise in defaults.
Finally, keep an eye on the spreads for credit
default swaps (CDS), contracts that insure a buyer of debt against the
possibility of default. The spread represents the annual cost paid by
the buyer of the credit protection; the higher the spread, the more
skeptical the market is of the debtor's ability to repay.
Monitoring the heavily traded CDS market for sovereign debt is a good way to gauge
the prospects of struggling European economies,
says William Mast, director of fixed-income indexes for Morningstar. As
of late October, for example, France's five-year CDS spread stood at
1.9 percentage points, meaning it costs an average of $190,000 a year to
insure $10 million of debt. That's almost double the cost investors
paid for that same protection in January, a reflection of the mounting
worries that the eurozone debt crisis could deteriorate into a
full-blown economic disaster.
Until spreads tighten again, it makes sense to stay cautious.
--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This article is from the November 7, 2011 issue of Fortune
.
