The Most Important Market Indicator I’m Following Right Now

Last week, I noted that investors have high expectations for the future. In the long run, investors around the world are expecting average annual returns of 14.5% after inflation. In the United States, expectations are even higher at 17.5%.

Those numbers were based on a survey — and surveys are an important source of information. It’s important to understand what investors say… but it’s also important to look at what investors do (with their money).

A Glance At The Bond Market

This week, I noticed that what investors are saying and doing is in sync. Lately, investors are putting their dollars behind their opinions that the future will be bullish.

One way to gauge how bullish investors are is by looking at the bond market. A simple indicator to follow is the spread between low-grade corporate bonds and Treasury notes. The spread is the difference between the yields.

Low-grade corporates are bonds just one level above “junk.” Bond rating agencies like Moody’s believe companies issuing these bonds have enough cash to pay their debts in good times but could miss payments in an economic downturn.

Moody’s assigns a Baa rating to these bonds. When the economy is growing, bond investors buy corporates to take advantage of their higher yields. This increase in buying drives rates on Baa bonds down, and the spread, or difference, between Baa rates and Treasury notes falls. When risks rise, bond traders move to Treasuries and the Baa spread rises.

Right now, as the chart below shows, risk is low and falling.

Source: Federal Reserve

This indicates that investors are willing to accept risk.

In addition to providing insights into how risk averse investors are, this spread can also be used to gain insights into the stock market.

To use this information as a stock market indicator, we can compare the level of the spread to its value a year ago. When we see a year-over-year increase in the spread, it means risks in the stock market are relatively high. Over the long run, avoiding stocks when this simple indicator is bearish would beat a buy-and-hold strategy by a wide margin.

This indicator is valuable because it has given a signal ahead of almost every major stock market downturn since 1919 when data first became available. In the past 100 years, it has missed only two stock market declines of more than 15% — one in 1933 and another in 1942.

Currently, this indicator is on a “buy” signal. But it could reverse quickly after the rapid decline in the spread that we’ve seen over the past year. This is definitely an indicator that investors should follow in the coming months.

What My Indicators Say Right Now

My Income Trader Volatility (ITV) indicator remains bullish and the SPDR S&P 500 ETF (NYSE: SPY) continues moving toward my price target of $440.

ITV (red line) is crossing above its moving average (blue line). ITV is similar to the volatility index (VIX) in that it rises as prices fall. Its current position, just below the moving average, points to potential strength in stocks.

Our last chart this week shows my Profit Amplifier Momentum (PAM) indicator, which is bearish.

PAM is designed as a short-term indicator. The red bars are bearish, and the green bars are bullish. Its bearish crossover is a potential indicator of weakness. Downward momentum seems to be accelerating, and that indicates the market could reverse soon.

A “down” move is likely in the short term. It remains to be seen if last week’s new highs mark the top… or if stocks can rally once more before turning down.

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