Stocks at Cheapest Ever Relative to Credit

You’ve heard me say countless times that credit markets lead the equity markets in both directions, on the way up and on the way down. We saw the down version in 2007-2008 and we’re seeing the up version in 2009-2010.

I checked in with one of my top credit market sources, who has to remain nameless, to catch his view on how fixed income has been acting since stocks took the up elevator at the start of September. And you may be surprised to hear what he said. The guy does not mince works. He says that credit has enjoyed an even stronger start to autumn that stocks. And that the stock market is ”now the cheapest it has ever been relative to credit” since the junk bond market began in the 1980s.

Wow, really? Tell us more.

“I thought we would get a corporate bond issuance surge this month, and that happened as there was a broad spectrum of companies that brought bonds to market,” he said. “But instead of rising in the face of this issuance, junk yields and spreads actually�narrowed. The voracious appetite of credit investors continued as if there wasn’t a care in the world. I knew this was likely because of the need of our nation’s pension funds to lever up, but the strength of the credit market surpassed even my own high expectations.”

In contrast to the devil-may-care attitude of credit investors, the analyst observes that equity investors keep flinching at every flicker of bad news. He noted with that equity investors “panicked over the foreclosure situation” last week, acting as if the voracious credit investors wouldn’t fund any bad mortgages that made it back onto bank balance sheets. He finds that amusing, because credit investors will fund just about anything that breathes at this point.

So his main observation is that even though stocks have risen briskly in September and October, they are falling farther and farther behind the value of credit.

The upshot: For most of this year, the analyst has been writing that credit has acted as if the S&P 500 was already north of 1500.�Now he argues that credit is acting as if the S&P is already north of 1700, which is 150 points above the October 2007 high.

The analyst is quick to point out that this does not guarantee that stocks will get there, as it is just a valuation tool. Yet, this does mean that stocks have never been cheaper relative to credit. And that in turn means that companies will bond funding to enhance shareholder value via more buybacks and mergers — a cycle that typically lasts years, not months.

In summary, although there are ample things to worry about in the world, ranging from a cyclical slowdown in industrial production to deep weakness in residential construction, the Fed and the credit markets are very supportive of higher equity prices. So every setback should be seen, at least through the end of the year, as an opportunity to cull out weaker holdings and put more funds to work.

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