The ongoing return to 'normal' boosts stocks

In attempting to explain the market rally of the past 10 months and predict where we go from here, Vincent Delisle can boil it down to one dominating theme: Normalization.

Basically, the Scotia Capital strategist says, the equity rally can be seen through the lens of the gradual return to normal for underlying conditions in the financial markets, after the distinctly abnormal conditions at the frenzied peak of the credit crisis. That process is continuing.

The first phase of normalization for stocks, Mr. Delisle said in a report this week, was the return of risk premiums to more normal levels. This has been evident in the U.S. market's favourite indicator of equity risk - the VIX volatility index, which, after peaking above 80 during the crisis, now sits at 17, a 20-month low and comfortably within its historical normal range of 10-20.

Credit spreads - another key indicator of risk, not just for equities but more broadly for all financial markets - have been reverting to more normal levels, and they've come a long way. But they're not done yet - and this is where Mr. Delisle sees further opportunity for stock-market gains.

SPREADS DOWN, STOCKS UP

Mr. Delisle noted that over the past decade, stock performance on the S&P 500 has been closely related to credit spreads (the gap between corporate and government bond yields), with a 67-per-cent positive correlation. In short, when spreads are widening, stocks fall, and when spreads are narrowing, stocks rise.

The good news for stocks is that credit spreads, despite their dramatic narrowing over the past year, are still at about 250 basis points - still well above their historical average of 215 basis points. (A basis point is one-hundredth of a percentage point.) If you just look at the past 10 years, spreads have been routinely well under 200 basis points.

The implication is that spreads can and will continue to narrow this year - supported by underlying fundamentals, such as improving profits and general health at the corporate debt issuers. And stocks, based on their high correlation, should follow suit.

"As long as spreads keep narrowing, equity markets will be biased higher," he said.

NEXT UP:

POLICY NORMALIZATION

However, the next phase of normalization might not be so favourable for stocks, he said. That's governments and central banks unwinding the stimulus they've injected into the economy.

"Once risk premiums have fully reverted back to more normal levels, the next normalization should hit monetary and fiscal policy," he said. "This second normalization phase should prove much more challenging for financial markets, as rising rates cap growth potential and risk appetite."