#46 S2N: Spreads too thin

I will be offline for the next 48 hours. I have written tomorrows letter, which is scheduled to be sent automatically. I had the best intentions to write Wednesday’s today, but I spent way too much time on today’s spotlight trying to get a backtest to perform the way I wanted.

Today’s Spotlight

I came across this statistic on the weekend.

The yield curve has been inverted for over 500 days We’ve only seen this 3 times in history: 2008, 1929, 1974. All 3 saw > 50% stock market drawdowns.

Unfortunately, I don’t have yield data going all the way back to the Great Depression. Let me take you through my thinking. By the way, there are a number of interpretations of the classic yield spread. Some people take the 10-year minus the 2-year; others take the 10-year minus the 3-month Treasury yield.

I have shared in the past a simple backtest of the 10/2 yield curve. Today I will share the 10yr/3m. In this very basic strategy, you sell the SP500 when the yield is negative (inverted) and you buy the SP500 when it is positive. The results show no change from a buy-and-hold strategy when looking at risk-adjusted returns (Sharpe Ratio). By the way, that is my heuristic, I think, in risk-adjusted terms. Always.

From this, you can see that reacting to headlines is not a sensible way to invest. I am not disagreeing with the statistic I quoted at the start. They have more data, and they also look at more than just an inverted curve; they look at the time the spread is negative.

I thought I would add to this discussion something that has been bothering me. Corporate bond spreads are too low, in my opinion. This measures the spread of corporate debt bond yields over government bonds. Nobody cares about my opinion; so let us look at some more analysis.

In the chart below I have inverted the y-axis of the corporate bond spreads and compared their performance with the SP500. What you can see is that their is a very clear visual relationship between extremes in corporate spreads and big tops and bottoms in the SP500. This doesn’t always mean that you can trade the relationship. The challenge with all these relationship-styled trades is that you often only know that a top or bottom has been established after the fact. I look for a statistically significant edge with these relationships. This means that most times there is nothing of substance to report. If edge was so easy then we would all be making money most of the time.

To add another piece to the puzzle, I track the NY Fed’s weekly Corporate Bond Distress Index. As you can see the various categories, investment grade (IG) and high yield (HY/Junk) are not pointing to any stress in the system. Remember, we are moving from the lowest interest rate environment in history and we are potentially going to be in an elevated interest rate environment for some time. We have China’s property market and economy spluttering. I think it is just a matter of time for spreads and corporate bond stress to move to a more normal level.

I have a hard stop in 30 minutes and feel too pressured to complete a backtest of a more sophisticated strategy for the yield spread (I spent more than 3 hours on it today and am still not happy). I will revisit it in the coming weeks.

S2N Observations

The Nasdaq had a 2% sell-off on Friday. I thought I would plot the VXN, which is the volatility index of the Nasdaq 100, on a chart. What is clear is that volatility is still very low, and people are not too worried. Extreme’s on either end are usually important signal generators.

Having said that, 2 of the hottest stocks playing in the AI space had a shocker on Friday. The poster child of AI mania, NVIDIA, dropped 10%.

I wrote a few weeks ago that there was another AI player, Super Micro, that was having even stronger % returns for the year than Nvidia. Both companies were incorporated in the same year and are on amazing journey’s. Well, on Friday, Super Micro dropped a whopping 23%.

Of course, these are jaw-dropping drops but we are quick to loose the context of the pullback. Nothing grows so quickly without having big drops along the way. You can see these stocks are still up a lot. Look at their one-year returns after the drop. Nvidia 181% and Super Micro 560%, so don’t shed too many tears. Save that for the buyers on Thursday.

Something else that caught my eye that I thought was worth sharing is this chart. In a nutshell, the green line is the ratio of performance between the SP500 and a Commodity Index. You can see that it has been an incredibly good fit for more than 30-years. If this ratio continues to fall, it has typically led the SP500 in the past. Let’s see how this unfolds.

I am including a chart of cocoa again, as it went up another 3% on Friday. This is getting a little ridiculous. As a trader who loves trading extremes, this is very tempting to sell. I am going to say its worth a really small short position.

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