Skip to Content
Stock Strategist Industry Reports

Are Rising Financial CDS Spreads a Bearish Sign for Equities?

These credit default swap levels predicted the last sell-off, but a repeat is no sure thing.

Mentioned: , ,

In late 2007, credit default swap levels jumped for the large U.S. financials as the credit markets grew concerned about the health of the U.S. financial system. This jump foreshadowed a large drop in equity prices several months later. During the past several months, a very similar jump in financial credit spreads has occurred, and while a significant fall in equity prices is possible, it appears that much of the cost of another financial crisis is already priced into the equity market. While the trend in CDS spreads is troubling and fixed-income markets beat the equity market to the punch in 2007, a plausible case could be made that this time fixed-income markets are just catching up to the equity markets.

The financial crisis of 2008 wreaked havoc on equity investors; in early 2009 the S&P 500 Index traded at less than half of its October 2007 high. The crisis was foreshadowed by the credit markets through a jump in credit spreads for the large U.S. banks. In Exhibit 1, we graph the history of the S&P 500 Index versus an average of CDS levels for the three large U.S. banks:  Bank of America (BAC), Citigroup (C), and  J.P. Morgan Chase (JPM).

The graph shows that CDS levels jumped more than 100 basis points in the last quarter of 2007, ending at approximately a tenfold increase from where they had been at the beginning of the year. While CDS levels did drift lower in early 2008, this improvement was only temporary, and they continued to worsen after that with a dramatic peak in early 2009 of more than 400 basis points. In late 2007, the credit markets signaled a potential problem with the financial system. Had equity investors exited their positions at that time, they would have saved a large portion of their capital. The financial system is the main provider of credit and lending for companies. This credit can be thought of as oil for the economic engine. Problems with the financial system usually result in a lack of adequate credit being provided. This, in turn, causes the economic engine to seize up. Therefore, financial sector results can often be a valid predictor for general economic conditions, especially in times of stress.

Exhibit 1: Jump in Financial CDS Spreads Foreshadowed 2008 Equity Sell-Off

In the past few months, CDS levels for the large U.S. banks once again have experienced a dramatic jump. This can be seen in Exhibit 1, with a jump in CDS levels from about 125 basis points last summer to almost 300 basis points at the end of 2011. A possible European crisis caused by sovereign defaults or a collapse of the euro currency has increased credit market concerns over how the U.S. financial system will be affected. The key question is, "What does this mean for equity investors?" By simply looking at the overall index level, it would be easy for an investor to think that bank CDS levels and the stock market are not in alignment. If the 2007-08 scenario were to repeat itself, one could expect that given the jump in bank CDS levels, the equity market could sell off dramatically. This analysis, however, would be a little too simplified.

By just looking at the overall index level, investors would be ignoring the growth in earnings that has been experienced in the past several years. In Exhibit 2, we attempt to account for this problem by comparing the S&P 500's price/earnings ratio to those same financial CDS levels. Here, the picture is a little different. The exhibit shows that current P/E levels are at their lowest point in the past five years and that any future possible financial crisis already could be priced into the market. However, looking just at P/E ratios also could be too simple. The key to the P/E ratio is not just the numerator (price), but also the denominator (earnings). This fact is best demonstrated by 2009's jump in P/E where the ratio's increase was driven by the falloff in earnings as opposed to any dramatic price increases. With that in mind, we could consider that the market is projecting a significant drop in earnings. Still, however, the overall low historical P/E ratio would make a significant drop in the S&P 500 seem difficult even with a large decline in earnings.

Exhibit 2: Price/Earnings Ratios Are Near Their Lowest Levels of the Past Five Years

To account for both the overall index level with growth in earnings, as well as the numerator/denominator issue as experienced through the P/E ratio, we compared the S&P 500's price/book ratio to the financial CDS levels. In Exhibit 3, we can see a significant drop in early 2008, several months after the jump in CDS levels, much like the other two graphs. Like the P/E graph, however, we see that the price/book ratio is at, or very near, the lows experienced in early 2009. Like the P/E graph, this would appear to show that a possible financial crisis is already priced into the market.

Exhibit 3: Price/Book Ratios Are Near Their Lowest Levels of the Past Five Years

Overall, it would be difficult to imagine a scenario where a worsening European crisis would not cause a sell-off in U.S. equities. When reviewing P/E and P/B ratios, however, it appears that the equity and credit markets are not as misaligned as they were in late 2007 and early 2008, and that the dramatic sell-off experienced then is less likely today. We are not overly concerned. We would note, however, that every crisis is different, and it is extremely difficult to predict the outcome of a European financial collapse.

James Leonard does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.