And now for something completely different. A bit of macro and a bit of factor relative performance: what happens when yield spreads and small caps diverge from the S&P 500?

High Yield Spreads

First, let’s play with some macro-style data. Below you’ll find the SPY and BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread (a high yield bond spread index)  plotted against SPY.

Obviously the two are inversely correlated as spreads tend to widen in bear markets. Very low values are a sign of overheating. We’re still about 130 bp away from the pre-crisis lows, so in that regard the current situation seems pretty good. There’s a bit more to it than that, though.

First, divergences. When stocks keep making new highs and spreads start rising, it’s generally bad news. Some of the most interesting areas to look at are July ’98, April ’00, July ’07, and July ’11.

Also interesting is the counter-case of May ’10 which featured no such divergence: the Flash Crash may have been the driver of that dip, and that’s obviously unconnected to the macro situation in general and high yield spreads in particular.

So, let’s try to quantify these divergences and see if we can get anything useful out of them…on the chart above I have marked the times when both the spread and SPY were in the top 10% of their 100-day range. As you can see, these were generally times close to the top, though there were multiple “false signals”, for example in November ’05 and September ’06. Here are the cumulative returns for the next 50 days after such a signal:

Much of this effect depends on overlapping periods, though, so it’s not as good as it looks. Still, I thinks it’s definitely something worth keeping an eye on. Of course right now we’re pretty far from that sort of signal triggering as spreads have been dropping consistently.

Size: When Small Equities Diverge

Lately we’ve been seeing the Russell 2000 (and to some extent the NASDAQ) take a dip while the S&P 500 has been going sideways with only very small drawdowns. There are several ways to formulate this situation quantitatively. I simply went with the difference between the 20-day return of SPY and IWM. The results are pretty clear: large caps outperforming is a (slightly) bullish signal, for both large and small equities.

When the ROC(20) difference is greater than 3%, SPY has above average returns for the following 2-3 weeks, to the tune of 10bp per day (IWM also does well, returning approximately 16bp per day over the next 10 days). The reverse is also useful to look at: small cap outperformance is bearish. When the ROC(20) difference goes below -3%, the next 10 days SPY returns an average -5bp per day. Obviously not enough on its own to go short, but it could definitely be useful in combination with other models.

Another interesting divergence to look at is breadth. For the last couple of weeks, while SPY is hovering around all time highs, many of the stocks in the index are below their 50 day SMAs. I’ll leave the breath divergence research as an exercise to the reader, but will note that contrary to the size divergence, it tends to be bearish.

In other news I’ve started posting binaries of QDMS (the QUSMA Data Management System) as it’s getting more mature. You can find the link on the project’s page.  It’ll prompt you for an update when a new version comes out.