As Go the Credit Markets, So Go Stocks!

I have a simple rule I follow when it comes to investing in markets like these: As go the credit markets, so go stocks! Or stated another way, if you spend all your time watching stocks like Amazon.com or Apple, you’re going to regret it!

Why bring this up?

Because when I watch the market coverage on CNBC, I usually hear commentary from an endless parade of bullish fund managers. They say that you should buy transportation and manufacturing stocks for this and that reason, or that you should buy technology stocks because it’s the “seasonally strong” period for tech.

Me?

I think these guys wouldn’t know a Euribor-OIS spread or 2-year swap spread if it hit them on the nose! But just like they did in the LAST phase of the market meltdown, those obscure credit market indicators are LEADING the stock market. They exploded higher — signaling a flight from risk — BEFORE stocks collapsed in 2007-2009 … and they’re exploding higher again.

Signs of an Impending Meltdown
Are There — Pay Attention, Please!!

In order to understand why these kinds of esoteric indicators are so important, you have to understand what they are! So get out your pencils folks … I’m going to give you a quick credit market primer.

The Euribor-OIS spread is up first. It measures the difference between what banks would have to pay to borrow money from each other in the Euribor market (the European equivalent of the LIBOR market where dollar-based loan rates are set) and what they would have to pay by entering into an overnight indexed swap.

Normally, the two rates track each other very closely. But when the spread blows out, it’s a sign that liquidity fears are surging — essentially, that banks are afraid to lend to each other because they’re worried the banks they’re trading with won’t be able to make good on their promises.

Now take a look at this chart. You can see that this spread is soaring — to 78 basis points at last count. That’s the highest going all the way back to early 2009.

Then there’s the 2-year swap spread. Interest rate swaps are derivatives contracts that banks and other parties sign. They allow parties to swap fixed-rate payments for floating-rate payments on some fixed amount of underlying debt, and they’re designed to mitigate interest rate risk. The spread tells you the difference in cost between a 2-year swap and the yield on a 2-year Treasury note.

In normal times, the spread is relatively narrow because being on one side of a swap contract or buying a Treasury of equivalent maturity delivers roughly the same result. But when banks get increasingly nervous about the ability of their counterparties to make good on their derivatives contracts, the cost of entering into swaps surges.

It exploded higher in 2007-2009. And what do you know, it’s rising again. Just look at the chart below and you’ll see this spread has blown out to 34 basis points, the highest since last summer. That’s nowhere near the 167 points we saw a few years ago at the depths of the credit crisis. But that just tells me we have much higher readings yet to come!

Next Up: Equity Risk Indicators to Surge,
Stock Prices to Plunge!

So what’s going to happen next? What are these credit market indicators telling me to expect?

A surge in the CBOE Volatility Index, or “VIX” as it’s known. I wouldn’t rule out a rise to the 60s from the current level in the high-30s. And along with that surge, we’ll get a collapse in stocks. My longer-term target, as I spelled out in last week’s column, is around 7,000 on the Dow.

The decline won’t happen in a straight line, of course. European and U.S. policymakers will try to stand in the way … just like they did in 2007-2009.

This week the ECB and other central banks agreed to extend longer-term dollar loans to European banks to tide them over for a bit longer. The heads of state in Germany, France, and Greece also got together for a “kumbaya” phone call, then promptly announced that everything is peachy!

But the moves are straight out of the crisis playbook. Over and over, you see a crisis erupt … policymakers respond with some new whiz-bang program, sparking a short-covering rally … then the crisis returns in spades because the underlying problems haven’t been solved!

Heck, the central banks even chose the Thursday morning of options expiration to roll the latest program out! That’s designed to inflict maximum pain on short-sellers, a move first rolled out by former Fed Chairman Alan Greenspan years ago and used repeatedly by Ben Bernanke in Phase I of the crisis! If it weren’t such a sad attempt at market manipulation, it’d almost be laughable.

Finally, it’s not JUST the credit markets that tell me a major Dow plunge is forthcoming. It’s the continuing flood of weak economic data.

Take the latest National Federation of Independent Business report …

The group’s index sank to 88.1 in August from 89.9 in July, the sixth drop in a row. That left the index at a 13-month low, with the group’s chief economist William Dunkelberg saying,

“Hope for improvement in the economy faded even further through the month.”

In fact, a subindex that tracks how optimistic businesses are about the future plunged to the lowest level since 1980!

Meanwhile, retail sales flatlined in August. That was a sharp downturn from the 0.3 percent growth we saw in July, and it missed economist expectations. If you strip out autos, gas, and building materials to get the “core” sales figures used to calculate GDP, you get a big fat goose egg too — the weakest reading so far in 2011.

As if that weren’t enough, the New York Federal Reserve’s index of regional manufacturing sank yet again — to -8.8 from -7.7 in August. Economists expected an improvement, but what we got was a decline to a 10-month low! The Philadelphia-area index also disappointed — coming in at -17.5 against expectations for a reading of -15.

Bottom line: Rallies are meant to be sold. Or better yet, use them to add more exposure to downside hedges and inverse ETFs — investments that rise in value when stocks fall. That’s precisely what I’m doing. And if I’m right about where the market is headed, my subscribers will profit handsomely!

Interested in joining them? I sure hope so!

All you have to do to get started is click here and watch my free video, America’s Financial Doomsday. It will tell you why I believe the markets are going to fall out of bed, and more importantly, what to do about it … before it’s too late!

Until next time,

Mike