The Credit-Equity Chart, Revisited

This morning I said I’d love to see a chart showing how bond spreads have evolved relative to stock prices, connected chronologically. Next thing I know, this chart arrives in my inbox courtesy of the great Matthew Turner:

cdx.jpg

You start reading with the blue line (2005), which then becomes the red line (2006) and the black (H1 2007). The green line (H2 2007) actually starts at the top, with the credit crisis of last summer, and ends with slightly lower spreads, but they gap out even more in 2008, which is the purple line. The y-axis is the 10-year CDX, in basis points; the x-axis is the S&P 500.

So it’s pretty clear that the last time stocks were at their present levels, the market was discounting corporate earnings at a much lower interest rate. In other words, expectations of future corporate earnings would seem to have risen since 2006. After all, a stock price is just the discounted value of future earnings, right? All other things being equal, if the discount rate spikes upwards, then stock prices should fall. But of course all other things are not equal: right now we’re in a period of massive credit-market dislocations – much more massive than any losses being suffered in the stock market.

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