Is the S&P 500 Correcting Or Beginning To Collapse?

Tom Sowanick is Co-President and Chief Investment Officer of Omnivest Group in Princeton, N.J.

The equity market correction that has been underway since October 17 has not been corroborated by widening of credit spreads.

Since October 17, the S&P 500 Index has fallen approximately 3 percent, yet high yield and investment grade spreads have narrowed by approximately 3 basis points (bps). The fact that credit spreads have remained relatively stable during this equity market sell-off, leads us to believe that the equity market correction is nothing more than that -- a correction.

Economic data has continued to improve relative to estimates since mid-September of this year. The Bloomberg ECO Surprise Index had a negative reading of 0.319 percent on September 14th and now sits at a positive 0.117 percent. This indicator suggests that the trend of economic data is now on a sustained upward trajectory, albeit at a modest pace.

Credit default swaps (CDS), a measure of demand for insurance to protect against widening spreads, have also been stable. The high yield consumer discretionary CDS has narrowed from 474bps in mid-October to 468bps as of today.

Similar improvement has occurred in the high yield finance CDS market where spreads have come in from 522bps to 517bps during the same time period.

However, disappointing earnings for certain technology companies has resulted in high yield technology CDS rising from 653bps to 731bps.

The absence of a meaningful movement in CDS spreads and the absence of a widening in credit spreads strongly suggest that the correction in the equity market will be short-lived.

We recognize that there has been an increase in market chatter about the risk of widening high yield spreads; however, we have seen no evidence to substantiate these fears.

And while the search for yield has clearly brought corporate borrowing costs lower, a more deciding factor pushing borrowing costs lower has been the zero interest rate policy (ZIRP) embraced by the Federal Reserve.

The Federal Reserve announced today that they would “keep the federal funds rate at 0 - 1/4 percent.... at least through mid-2015”.

With the federal funds rate anchored at near 0 percent for the next 2-1/2 years, investors simply have no choice but to look towards lower quality assets to produce incremental income.

The question becomes -- are investors paying too much? In some cases, the answer is undoubtedly yes.

For example, the PIMCO High Income Fund is currently priced at a 45.68 percent premium to its net asset value (NAV), down from a recent premium high of 70 percent, whereas the Western Asset High Income Opportunity Fund is trading at 3 percent premium to its NAV.

Investors looking for income need to not only pay attention to the economic fundamentals before investing, but also to the cost structure of each investment.

The Federal Reserve’s commitment to its dual mandate of stable prices and full employment should continue to give investors confidence to remain fully invested and to seek opportunities when market corrections occur.