DON´T MISTAKE MARKET CALM FOR BEING OUT OF THE WOODS / THE WALL STREET JOURNAL

Don’t Mistake Market Calm for Being Out of the Woods

Investors should search the past for lessons about where we are in the market cycle. 2005 was an instructive momento 
By Richard Barley

REGIME SHIFT
Change from a day earlier in S&P 500 stock index


Is the fuss all over? February’s sharp fall in stocks has faded, with the S&P 500 only 3% below its January peak and up 4% for the year. The rise in Treasury yields has paused and corporate-bond spreads are still tight.

But now isn’t the time to get comfortable with the apparent calm.


STOCKPILE
Assets on central bank balance sheets
Source: Citigroup



The underlying economic picture in March is muddier than in January. Some survey data, like purchasing-managers indexes, suggest that growth may have peaked, while inflation is likely to pick up. Sure, last week’s U.S. jobs data pointed to continued expansion, but central banks aren’t backing down from reducing stimulus. And for those who believe the flow of central bank asset purchases are what matters for markets, rather than the vast stock accumulated, then the period ahead looks troubling. That flow is diminishing.

Even the apparent lack of spillover from the implosion of stock-market volatility products might not be that reassuring. Investors elsewhere, not directly affected by the financial fallout, may be underplaying the significance of this event.

A worker labors at a construction site in Washington, DC. U.S. jobs data pointed to continued expansion last week. Photo: mari matsuri/Agence France-Presse/Getty Images 


So which is it? There has been lots of guessing about where we are in the cycle and a search for historical parallels. Is this 1994, a bond market bump before a huge leg up in stocks? Or 1998, when Russia’s default sent markets briefly into panic? Or is this 2007, moments before a crash?

A lesser-noticed moment worth studying is the credit correlation blowup of 2005. Markets were shaken then after auto makers Ford Motor Co mpany and General Motors Co mpany were downgraded to “junk,” sending bets made in the credit-derivatives market awry. That too didn’t have immediate consequences for wider markets or the economy: the corporate-bond market bounced back in the second half of 2005. And it wasn’t in the area of the market—housing—that ended up causing the crisis just over two years later. 


EARLY WARNING?
Spread of U.S. investment-grade corporate-bond yields over Treasurys

Source: ICE BofAML index via FactSet,


But it was an early sign in that cycle that investment strategies that rely on conditions persisting can reverse swiftly and unexpectedly. In the 2005 case, rather than betting on volatility remaining low, investors were using complex derivative trades to bet that corporate bond prices would broadly move in sync. When Ford and GM’s ratings were cut, that bet went badly wrong, as the auto makers’ bonds were slammed, while the rest of the market was steadier. The return available suddenly wasn’t sufficient for the risk taken.

The same is the case for investors who were betting this year that volatility would stay low.

Tight corporate-bond spreads and still-lofty stock valuations speak to a persistent belief that the world hasn’t changed, however.

One could read the start to 2018 in a reassuring way: the global growth story may yet win out.

But investors should probably take the turbulence seriously. Markets are changing. Now isn’t the time to hit the snooze button.