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The stock/corporate bond disconnect

This chart compares the S&P 500 index with the price of HYG (a large high-yield index bond fund). The correlation of these two prices was an impressive 0.95 throughout the second half of last year. The correlation has since dropped to 0.67 over the course of this year, and in the past two months (since mid-June) the divergence has become noticeable: bond prices have tracked higher as equities have weakened (see chart below for a detailed look). Only a part of that divergence can be attributed to falling yields on government bonds—most of the divergence is explained by a tightening of corporate spreads which began in June.

This means that in the past two months the equity market has grown more pessimistic about the outlook for corporate earnings while the bond market has grown more optimistic about the outlook for corporate defaults. This is, to put it mildly, a curious development, since normally the outlook for earnings tracks the outlook for defaults quite closely.

How to explain this? Perhaps the equity market is too pessimistic, or the bond market is too optimistic. An optimistic interpretation, to which I'm partial given my bond-market background and experience, would say that the bond market is the leading indicator, especially at key turning points. There have indeed been times in the past when the bond market has led the stock market. For example, corporate bond spreads started tightening in earnest in the last two months of 2002, while the equity rally only really got underway several months later. Then, corporate bonds spreads (and in particular swap spreads) started widening in early 2007, but equities didn't start falling until much later that year.

I think this all adds up to one more reason to think that the equity market is much too gloomy these days. Earnings have been growing strongly, and there are plenty of signs that suggest that the economy is not falling into the double-dip recession so many seem to be calling for these days.

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