Mike Larson: I have a simple  rule I follow when it comes to investing in markets like these: As go the  credit markets, so go stocks! Or stated another way, if you spend all your time  watching stocks like Amazon.com or Apple, you’re going to regret it!

Why bring this  up?

Because when I  watch the market coverage on CNBC, I usually hear commentary from an endless  parade of bullish fund managers. They say that you should buy transportation  and manufacturing stocks for this and that reason, or that you should buy  technology stocks because it’s the “seasonally strong” period for tech.

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Me?

I think these  guys wouldn’t know a Euribor-OIS spread or 2-year swap spread if it hit them on  the nose! But just like they did in the LAST phase of the market meltdown,  those obscure credit market indicators are LEADING the stock market. They  exploded higher — signaling a flight from risk — BEFORE stocks collapsed in  2007-2009 … and they’re exploding higher again.

Signs  of an Impending Meltdown Are  There — Pay Attention, Please!!

In order to  understand why these kinds of esoteric indicators are so important, you have to  understand what they are! So get out your pencils folks … I’m going to give  you a quick credit market primer.

The Euribor-OIS  spread is up first. It measures the difference between what banks would have to  pay to borrow money from each other in the Euribor market (the European  equivalent of the LIBOR market where dollar-based loan rates are set) and what they  would have to pay by entering into an overnight indexed swap.

Normally, the  two rates track each other very closely. But when the spread blows out, it’s a  sign that liquidity fears are surging — essentially, that banks are afraid to  lend to each other because they’re worried the banks they’re trading with won’t  be able to make good on their promises.

Now take a look  at this chart. You can see that this spread is soaring — to 78 basis points at  last count. That’s the highest going all the way back to early 2009.

Then there’s the  2-year swap spread. Interest rate swaps are derivatives contracts that banks  and other parties sign. They allow parties to swap fixed-rate payments for  floating-rate payments on some fixed amount of underlying debt, and they’re  designed to mitigate interest rate risk. The spread tells you the difference in  cost between a 2-year swap and the yield on a 2-year Treasury note.

In normal times,  the spread is relatively narrow because being on one side of a swap contract or  buying a Treasury of equivalent maturity delivers roughly the same result. But  when banks get increasingly nervous about the ability of their counterparties  to make good on their derivatives contracts, the cost of entering into swaps  surges.

It exploded  higher in 2007-2009. And what do you know, it’s rising again. Just look at the chart  below and you’ll see this spread has blown out to 34 basis points, the highest  since last summer. That’s nowhere near the 167 points we saw a few years ago at  the depths of the credit crisis. But that just tells me we have much higher  readings yet to come!

Next  Up: Equity Risk Indicators to Surge, Stock  Prices to Plunge!

So what’s going  to happen next? What are these credit market indicators telling me to expect?

A surge in the  CBOE Volatility Index, or “VIX” as it’s known. I wouldn’t rule out a rise to  the 60s from the current level in the high-30s. And along with that surge,  we’ll get a collapse in stocks. My longer-term target, as I spelled out in last week’s column, is around 7,000 on the Dow.

The decline won’t happen in a straight  line, of course. European and U.S. policymakers will try to stand in the way  … just like they did in 2007-2009.

This week the ECB and other central banks  agreed to extend longer-term dollar loans to European banks to tide them over  for a bit longer. The heads of state in Germany, France, and Greece also got  together for a “kumbaya” phone call, then promptly announced that everything is  peachy!

But the moves are straight out of the  crisis playbook. Over and over, you see a crisis erupt … policymakers respond  with some new whiz-bang program, sparking a short-covering rally … then the  crisis returns in spades because the underlying problems haven’t been solved!

Heck, the central banks even chose the  Thursday morning of options expiration to roll the latest program out! That’s  designed to inflict maximum pain on short-sellers, a move first rolled out by  former Fed Chairman Alan Greenspan years ago and used repeatedly by Ben  Bernanke in Phase I of the crisis! If it weren’t such a sad attempt at market  manipulation, it’d almost be laughable.

Finally, it’s not JUST the credit markets that tell  me a major Dow plunge is forthcoming. It’s the continuing flood of weak  economic data.

Take the  latest National Federation of Independent Business report …

The group’s index sank to 88.1 in August from 89.9 in  July, the sixth drop in a row. That left the index at a 13-month low, with the  group’s chief economist William Dunkelberg saying,

“Hope for improvement in the economy faded even further through the  month.”

In fact, a subindex that tracks how optimistic  businesses are about the future plunged to the lowest level since 1980!

Meanwhile, retail sales flatlined in August. That was  a sharp downturn from the 0.3 percent growth we saw in July, and it missed  economist expectations. If you strip out autos, gas, and building materials to  get the “core” sales figures used to calculate GDP, you get a big fat goose egg  too — the weakest reading so far in 2011.

As if that weren’t enough, the  New York Federal Reserve’s index of  regional manufacturing sank yet again — to -8.8 from -7.7 in August. Economists  expected an improvement, but what we got was a decline to a 10-month low! The  Philadelphia-area index also disappointed — coming in at -17.5 against  expectations for a reading of -15.

Bottom line: Rallies are meant to be sold.  Or better yet, use them to add more exposure to downside hedges and inverse ETFs — investments that rise in value when stocks fall. That’s precisely what  I’m doing. And if I’m right about where the market is headed, my subscribers  will profit handsomely!

Related ETFs: Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA), ProShares UltraShort S&P500 (NYSE:SDS), Direxion Daily Financial Bear 3X Shares (NYSE:FAZ),  iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX), Direxion Daily Small Cap Bull 3X Shares (NYSE:TNA), Direxion Daily Financial Bull 3X Shares (NYSE:FAS).

Until next time,

Written By Mike Larson From Money And Markets

Money and Markets (MaM)is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaMare based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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