Charts to watch when S&P 500 hits record high | a cautious investor

With the S&P 500 and Nasdaq 100 once again hitting record highs and the Dow Jones Industrial Average briefly surpassing 40,000 for the first time, what should we think about further upside for the stock benchmarks?

There are two common ways to play charts that move higher into uncharted territory. First, you can use technical tools such as Elliott Wave, Gann or pattern measurements to identify potential upside targets. I tend to avoid this kind of approach. Because I’ve learned that when something works, you want to keep it working for as long as possible!

Peter Lynch famously likened this approach to growing a garden. Selling winners and doubling down on losers is like pulling out flowers and watering the weeds! To keep a beautiful garden, you need to pull weeds and water the flowers. So in a portfolio context, this means riding winning stocks higher as long as they continue to benefit the portfolio.

Therefore, the second common approach is to become a trend follower, tracking an upward trend and looking for signs of a change in that trend. Below is one of the charts I currently use for general evaluation of the S&P 500.

This chart has three series starting with Bank of America’s High Yield Index Option Adjusted Spreads. If you’re confused by the long-winded title, let me simplify it. Bonds are quoted at a spread above the risk-free rate. Therefore, U.S. Treasury bonds are considered a “risk-free investment” because it is very unlikely that the U.S. government will fail to pay the interest on its debt. Any corporate bond issued by a particular company, by definition, carries additional risk than government bonds. So any type of corporate spread tells you how much extra return you should expect in return for taking on extra risk.

Many corporate bonds contain call options. This means that the bond may be repaid by the company before maturity. In this case, we are using an “option-adjusted spread”. That means removing that option in favor of comparing bonds on a more apples-to-apples basis. And this spread is based on high-yield bonds, or “junk” bonds, meaning bonds from risky companies with low credit scores.

So in summary, we are tracking how much investors demand spread bonds to take on the risk of junk bonds. We’ve plotted this series backwards because wider spreads mean additional risk, which usually means bad news for stocks. You can see that as the spread widens (lowering line in this chart), it tends to coincide with a downtrend in the S&P 500 (bottom panel). Conversely, spread narrowing tends to coincide with upward trends in major stock indices.

High-yield spreads are currently at their lowest levels in years, suggesting bond investors are expecting a low-risk environment for the foreseeable future. If spreads start to widen like they did in early April, that would be a bearish signal for stocks.

The middle series shows the VIX. This is because markets tend to rise in conditions of low volatility and stocks tend to fall in conditions of much higher volatility. I have displayed this series backwards. Because it is easier to compare volatility to the S&P 500 trend. The VIX is also at the lowest levels we have seen in the last two years, signaling a low-volatility environment that I will describe. If the VIX rises above 15, especially above the 20 level, this means a much more bearish environment for risk assets like the S&P 500 and Nasdaq 100.

To be clear, this chart is currently very bullish. The S&P 500 is trending upward with tight high-yield spreads and very low volatility. If credit spreads begin to widen and volatility increases, this could be a good opportunity for equity investors to question the sustainability of the bull market phase.

RR#6,

dave

P.s Are you ready to upgrade your investment process? Check out our free behavioral investing course!

David Keller, CMT

Chief Market Strategist

StockCharts.com

disclaimer: This blog is for educational purposes only and should not be construed as financial advice. You should not use any of our ideas and strategies without first evaluating your personal and financial situation or consulting a financial professional.

The author had no positions in any securities mentioned at the time of publication. All opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity.