The idea behind this week’s indicator is that corporate bond spreads can be used to anticipate changes in stock market earnings. This is because, historically, widening spreads are associated with economic weakness and poor earnings growth rates, while narrowing spreads tend to occur when economic growth is improving and corporate earnings are strong.
The top clip of the chart above shows the earnings per share of S&P 500 companies over the past four quarters. The indicator on the bottom clip shows the difference between medium-grade and top-grade corporate bond yields. In essence, this is a risk premium measure, meaning it shows the extra yield premium investors are demanding to invest in lower-quality bonds versus higher-quality ones.
Specifically, because the risk premium’s range can vary widely over time, this is calculated as a “deviation-from-trend” indicator. This is done by dividing the spread’s 3-month moving average by its 60-month (5-year) moving average. This ratio (multiplied by 100) is plotted in the chart’s lower clip. Higher readings indicate widening corporate credit spreads, while lower readings indicate narrowing spreads.
So, what is the indicator telling us today?
The main takeaway is that credit spreads are once again widening. As the bottom clip shows, the indicator has gone from the lower zone, indicating narrow credit spreads, to the upper zone, a sign of widening spreads. Historically, this has been a sign that corporate earnings growth is set to slow down considerably, to the tune of roughly -11.5% per annum, according to the performance box in the top left corner.
As you can see from the top clip (blue line), earnings are hovering near record highs. But they have started to come down recently. Based on this credit spread indicator, risk is elevated, and that means earnings will likely have more room to fall. All else equal, lower earnings growth leads to lower stock price returns—something to be mindful of as we navigate into next year.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.