Fear index ends at record high for second straight day

WJB in The WJS -- Odd Couple: Stocks and Credit Markets

DECEMBER 28, 2008, 11:42 P.M. ET EDT By By MARK GONGLOFF

The relationship between U.S. stock and credit markets is ending 2008 in fittingly dysfunctional fashion.

For much of the year, the two markets have been out of sync, with credit often worsening even as stocks rallied. Now, credit seems to be improving, but the stock market isn't.

Since Dec. 15, the difference, or spread, between the yield on "junk" corporate bonds and Treasury bonds has shrunk by two full percentage points, according to Merrill Lynch data. Other credit spreads have also narrowed sharply since the Federal Reserve took its key target interest rate to nearly zero and suggested it would keep rates low for a while.

Such spreads are a closely watched measure of how much risk investors and banks are willing to take when extending credit. Lower spreads typically mean they're more willing to lend. That's good news for corporations that want to borrow, and in turn helps economic growth and stock prices.

And yet the stock market doesn't seem to be responding. The S&P 500 is priced almost exactly as it was on Dec. 16, when the high-yield rally began. An iShares ETF that invests in junk bonds, the iBoxx High Yield Corporate Bond fund, has jumped 16% during that time.

One possible explanation is that credit markets are behaving as they sometimes do after dramatic Fed actions -- bears rush out, then bulls rush in but end up burned.

Something similar happened after big Fed cuts in September 2007 and January 2008, notes Brian Reynolds, chief market strategist at WJB Capitol Group. Each time, credit enjoyed a brief rally that ended in tears. This time, credit speculators may be hedging their bets by shorting stocks.

A more benign interpretation is that stocks are simply lagging credit, as they have for much of this crisis. Thin holiday trading could be exaggerating moves in credit or muting the stock-market response. That suggests the stock rally that began after Nov. 20 and petered out on Dec. 15 could resume with the new year.

But another possible explanation is that, while credit has improved some, it hasn't improved enough to offer assurance to stock investors. Even after their recent rally, high-yield bonds still fetch nearly 20 percentage points more than Treasurys, a bit wider than at the recent stock-market bottom on Nov. 20.

Such a spread means that bond investors are still worried enough about corporate defaults that they're demanding high yields -- the credit market is pricing in a level of corporate defaults commensurate with a depression, analysts say. The stock market has at worst priced in a nasty recession. If a depression is really in store, then stocks will eventually tumble to match the carnage in credit. Such a swoon could take the S&P to 600 or lower, according to some estimates.

Given the massive jolts of stimulus being fired at the economy, a depression seems unlikely. But the economy isn't healthy, either. The upshot: Credit could recover even further without sparking much of a response in stocks.