One of the bigger risk indicators for falling equity prices is the the yield curve and more importantly the credit spreads between various terms. My favorite to watch is the 2Y10Y spread which you can find at the St. Louis Federal Reserve:
This chart provides a nice indicator of how long it takes between an inversion and a recession.
January 1989
Stock Market Peak: July 1990
Official Recession Start: July 1990
February 2000
Stock Market Peak: March 2000
Official Recession Start: March 2001
December 2005 - No initial recession
September 2006 - No initial recession
May 2007
Stock Market Peak: October 2007
Official Recession Start: January 2008
Yield Spreads are a Leading Indicator
The reason why yield spreads are an indicator is because they are the baseline for credit risk pricing in consumer and commercial loans. The banking system expands the money supply by extending credit to (hopefully) worthy borrowers. As long as value is being created beyond the extension of credit and the cost of debt service, then all is good in the world. However, too much money in the system can start to lead to asset and commodity price inflation which compresses margins and disposable income. Banks recognize this inflation and raise borrowing costs to keep ahead of inflation.What is interesting is that Banks are typically lending shorter than original loan or bond terms due to repayment risk. A car loan of 6 years may be priced on a 2 year treasury plus a margin to capture risk premium. A 30 year mortgage might be based on a 7 or 10 year term due to families on average moving or refinancing. These behaviors explain the importance of the rates and how banks might react when spreads are inverted. Commercial Lines of Credit are usually based on the Federal Funds or Libor rate to ensure that there is no overnight credit risk when a company draws funds.
When short term rates start to exceed long term rates, companies are typically in a position where margins are compressing due to inflation so they begin to hoard cash. Wealthy individuals and organizations invest in short dated securities to capture yield with less time risk. Banks find fewer and fewer credit worthy borrowers and reduce loan/bond originations. This combination leads to a slowdown or decline in newly created credit as companies try to pay off existing debt with cash to reduce debt service burdens in order to become more credit worthy. The least creditworthy go bankrupt and general asset prices decrease.
Disinflation/Deflation Resets the Yield Curve with Higher Spreads
This cycle ultimately results in an interest rate reset where "disinflation" or deflation reduces asset and commodity costs, companies become more profitable, and discretionary income increases. The natural tendency is for long rates to be higher than short term rates to account for uncertainty. This leads to healthy and less-risky margins at banks.Ultimately there are several risks that I see. Financial stocks have been hammered by compressed yield spreads. There is too much money supply chasing too few credit worthy deals which is leading to smaller margins. Financial equities will lead the rest of the market downward until they figure out how to make an above normal profit. The increased money supply is starting to affect commodity prices so consumer discretionary spending is at risk to plateau or dip.
What's the Outlook?
With the current credit spread at 31 basis points and compressing by over 60 bps in the last 12 months, it's likely that we will have a 2Y10Y inversion in the next 6-12 months making the market at risk for a signficant correction anytime in the next 6-24 months. Perhaps there is one more equity leg up, but beyond that equity capital with interest rate risk is likely to have a very low reward/risk.
