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The U.S. stock market rally is ignoring worsening credit conditions

The following is an excerpt from Scott Barlow's collection of 10 charts that will define the markets in 2017. To view the entire series, click here.

There's no doubt that low interest rates and broader central bank monetary policy has helped equity markets. Lower bond yields made dividend-paying sectors more attractive, lowered financing costs for companies looking to buy back stocks, and measures like quantitative easing created more funds available for investment.

The upcoming year could provide a more painful lesson in how this trend has worked.

The Goldman Sachs Financial Conditions Index measures credit conditions – the ease with which financing is available – using a variety of indicators including equity prices, the U.S. dollar, Treasury yields, and credit spreads. The chart above shows that U.S. equities tracked financial conditions extremely closely for the past 12 months. Until the election.

The post-election period has seen a major divergence in the chart as the S&P 500 climbed higher as credit availability fell. (Note that the Goldman Sachs index is plotted inversely to better show the trend). This anomaly can be explained by the increase in bond yields and inflation expectations arising from Donald Trump's victory.

We now have a situation where financial conditions are tightening and U.S. equities, which have been – to a significant extent – dependent on credit conditions, continue to rally. In the weeks ahead, we will likely have a much better idea as to how much market activity is related to easy money.

I should also note that the high correlation between the financial conditions index and the S&P 500 is a relatively new phenomenon. A three-year chart would show little association between the two indexes and could be an anomaly.

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