Calm. Still. Halcyon. Serene. Placid. These are just a few of the adjectives that will invariably be used to describe last year’s stock market. In this case however, numbers, two in particular, illustrate better than words. According to Goldman Sachs, realized volatility for the S&P 500 was 6.7% last year, the second lowest on record. 2017 was also the only year on record in which the S&P 500 delivered a positive total return in every month of the year. A 20% return with no downside is literally as good as it gets.
Which of course leaves investors wondering if there is even the slightest chance we’ll be equally lucky in 2018. While the list of scenarios and events that can disrupt markets is endless, there is at least one quantifiable metric to watch: financial market conditions measured by credit spreads.
In the long term, valuations and the economic cycle, i.e. recessions, tend to drive performance; in the short term, both are less critical. In trying to forecast more common, “garden variety” corrections, financial market conditions have historically been more relevant than the next economic release. From my perspective, one big reason why 2017 was such a calm year for stocks was that it was an exceptionally calm year for credit.
Steady as she goes
To illustrate, it is useful to compare 2017 with late 2015/early 2016. Last year, credit markets turned in a remarkably steady performance. Not only were credit markets well-behaved on a year-over-year basis, they were calm throughout the entire year.
A typical measure of credit conditions are “spreads”—the difference between the yield of 10-year U.S. Treasury bonds and that of riskier bonds, such as high yield. When spreads are increasing, it is usually a sign of a selloff in risky bonds and buying of Treasuries. In 2017, high yield spreads (based on the Barclays High Yield Index) declined in 8 of 12 months, with relatively minor spread widening, 20 to 25 basis points (bps, or .20 to .25 percentage points) in March and August (see the chart below). By comparison, spreads increased by nearly 60 bps in December of 2015 and by roughly 75 bps in January of 2016.
U.S. high yield
This is important as rising spreads are one of the better leading indicators of market corrections. As monthly changes in credit spreads tend to be correlated, i.e. rising spreads in one month are often followed by a further rise the next month, spread widening often precedes equity market corrections.
Looking back over the past 60 years, changes of one standard deviation or more, roughly 60 bps, in credit spreads raise the odds of a 5% or bigger correction from 8.5% to more than 16%. Put differently, a 5% or greater correction is two times more likely to occur when credit spreads jumped in the previous month.
2018 seems to be starting where 2017 ended: a synchronized global recovery with low inflation and still benign financial market conditions. True, U.S. equity valuations are elevated, but this tells us little about the next few quarters. In summary, conditions still seem similar to the ideal ones we saw last year. But when this finally starts to change, credit markets will probably provide the first clue.