Is the Credit Market Flashing a Warning for Stocks?

While it hasn't always been this way, the bursting of the credit bubble has seemingly transformed debt markets into a leading indicator for stocks.

Back in late 2007, for example, when the S&P 500 index was rallying to new highs, one measure of credit market conditions was falling. That particular measure is a ratio of the iBoxx $ Liquid High Yield Index -- for which there is an exchange-traded fund, (HYG) -- relative to its investment-grade counterpart (LQD).

In hindsight, the negative divergence between the two should have been seen as a sign of trouble to come for the economy -- and for share prices: Soon enough, the S&P 500 and high-yield to investment-grade ratio were both moving downward.

Then, in contrast, when the stock market was making new lows in March 2009, the high-yield to investment-grade ratio was rebounding from a level above where it was in December 2008. Again, that divergence suggested -- correctly, as it happens -- that credit markets were anticipating a positive reversal of fortunes (however short- or long-lived it might prove to be) that was not yet apparent to equity investors.

With that in mind, it's worth pointing out that the two markets seem to be diverging once again. Following an 8% correction from its mid-January peak, the S&P 500 index has reached its highest level since the Lehman Brothers-inspired wipeout in the fall of 2008. At the same time, however, the high-yield to investment-grade ratio remains below the highs it recorded at the beginning of the year.

Although it's certainly possible that conditions in the credit markets will continue to improve to the point where this particular indicator also starts tracing out new short-term highs again, that remains to be seen. In the meanwhile, the fact that the two markets are somewhat out-of-sync could be an early-warning sign that share prices have once again gotten ahead of themselves.