Is the worst behind us? Maybe. Yet the appetite for risk is decidedly less vibrant than before the August-September meltdown. (Review Market Top? 15 Warning Signs.)
Consider high-quality bonds as represented by the Bank of America Merrill Lynch US Corporate A Option-Adjusted Spread. The yield spread between A-rated companies and comparable U.S. treasuries typically falls during periods when investors are feeling confident. This was the case throughout 2014. In contrast, when investors are concerned about their exposure to corporate credit, the spread widens. Indeed, the difference between A-rate corporate bonds and U.S. treasuries steadily rose in the summertime.
The Bank of America Merrill Lynch US Corporate A Option-Adjusted Spread spiked above 1.3 during the stock market lows in August and again at the start of October. It has since come down below a high-water mark in 2015, though it remains stubbornly high. Granted, there is nothing magical about this particular yield spread at 1.3 percent. On the other hand, a similar pattern of risk aversion occurred during the summer of 2007, right before the stock market’s bearish collapse (10/07-3/09).
Some equity advocates prefer to dismiss warning signs of risk-off behavior in bonds. They have been assigning blame for lack of interest in high-yield “junk” to the ailing energy sector. However, funds like iShares iBoxx High Yield Corporate Bond (HYG) and SPDR High Yield Corporate Bond (JNK) do not hold single A-rated bonds like Kimberly Clark (KMB) and Target (TGT).
“Single As” are highly rated because the risk of default is negligible and they are as reliable as rain in Seattle. What’s more, they usually exhibit narrow spreads with comparable treasuries. It follows that a substantial “risk-on” return to stocks from current levels is unlikely to occur without a meaningful retreat below 1.3% in the Bank of America Merrill Lynch US Corporate A Option-Adjusted Spread.
The notion that investors may still be spooked can be found outside of the bond arena as well. For instance, when the investment community is adding to its collective risk profile, high beta stocks in the PowerShares S&P 500 High Beta Portfolio (SPHB) tend to outperform less volatile stocks in the iShares USA Minimum Volatility Fund (USMV). This can be seen in the rising SPHB:USMV price ratio up through May of 2015. Unfortunately, the price ratio begin to decline in earnest during the summer. It hit new lows in August and September respectively. And while SPHB:USMV bounced off the September lows, the ratio is struggling to reaffirm a genuine uptrend.
Even the NASDAQ’s Advance-Decline Line (A/D) is sending mixed messages. One would think that if risk were truly back in vogue, advancing issues in the stock benchmark (NASDAQ) would be pummeling the decliners. That’s not happening… at least not yet. In other words, broader market participation in the October rally is spotty at best.
It is certainly possible that the worst for 2015 resides in the rear-view mirror. After all, the Federal Reserve’s inability to raise borrowing costs has sparked intrigue with respect to a “re-reflation” of asset prices in our muddle-through economy. On the flip side, with earnings as well as revenue both expected to decline for a second consecutive quarter (a.k.a. “earnings recession” and “sales recession”), some of that reflation may be kept in check. It’s one thing to consider the possibility that we’ve already seen the depths for 2015. It’s another thing to suggest that we will be heading for new heights anytime soon.