Investor appetite for risk is what drives markets higher as that appetite increases and lower as that appetite decreases.  One of the best measures of investor appetite for risk is the performance of high yield bonds in relation to U.S. Treasuries.  This spread shows a very close correlation to the performance of the S&P 500 and its behavior over the short term can actually help determine if a pullback is merely corrective or if it signifies something deeper.   

The chart below shows a spread between the iShares High Yield Bond ETF (HYG) and the Lehman 7-10 Year Treasury Bond ETF (IEF).  When the black line is rising, that means that high yield bonds are seeing more inflows than treasuries (bullish).  When the black line is falling, that means that treasuries are seeing more inflows than high yield bonds (bearish).  The S&P 500 index is also plotted (the red line).

Notice the high correlation between the spread and the S&P 500 over the last three years as the spread and the S&P 500 tend to peak and trough at roughly the same time.  There were instances, however, where the spread diverged from the S&P 500, and was in fact a leading indicator.  Notice in the chart below how the HYG:IEF spread bottomed in December 2009, a full three months before equities, showing that investors were beginning to move back into riskier assets.  Now take a look at late April 2010 toward the right side of the chart.  The spread made a double top formation as the S&P 500 pushed out to its late April high.  That was a negative divergence that showed risk flows were not supportive of the final push to the April high. 



Now let's take a closeup look at the current time frame and see what the relationship is telling us. 

First notice in the chart below how the spread began to break down in January 2010, before the S&P 500 began its sharp decline.  Now take a look at the May bottom.  The spread actually bottomed in mid May while equities continued to sell off.  That showed solid inflows into high yield bonds vs. treasuries which meant that investors were willing to take on higher amounts of risk - a good sign for equities.  A sharp rally followed.  Finally, take a look at the right side of the chart below.  Notice how the spread has broken out to a new high, showing that risk flows are still favorable in the market.  That bodes well for continued strength in equities over the near term. 



I am anything but a perma-bull on this market, but when the markets speak, we need to listen.