Junk Bonds vs S&P 500

Why Stock Investors Should Care What Happens in the Junk Bond Market
September 27, 2014
by Chris Puplava

Full article can be found at this link
http://bit.ly/1uw5PGp

For investors in the stock market what happens next in junk bonds will be crucial ahead since they often lead the stock market at important turns. For any doubters out there a simple history lesson over the last two bull markets will make this abundantly clear.

A look at the 2000 market top into 2003 is a good case of this as equity investors could have saved themselves a lot of pain by listening into the developments of the junk bond market. For example, credit spreads in the junk bond world (shown inverted in red below) began to deteriorate nearly a year before the S&P 500 peaked late in 2000 (see red bar) and warned of coming trouble. Similarly, while both spreads and the stock market put in a bottom late in 2002, the stock market sold off again into the spring of 2003 while junk bond spreads significantly improved and hinted that stock investors had it wrong and correctly called the bottom.

Following the script of 2000 and 2003, the message from the junk bond market correctly warned of a top and bottom in 2007 and 2009. By the middle of 2007, junk bond spreads began to deteriorate while the S&P 500 marched to a new high in October of 2007 (red shaded region) and warned all was not well in the financial markets. Similarly, spreads reached their nadir late in 2008 and staged a strong recovery and yet the stock market sold off and hit a new low in March 2009 before bottoming (green shaded region). Anyone listening to the junk bond market late in 2008 and 2009 may have ignored the financial press that the end of the world was upon us and could have snatched up stocks at cheap valuations.

Because of the tendency of the junk bond market to warn of significant turns in the stock market ahead of time, I constantly check in on their message and junk bonds are not singing a happy tune. Spreads began to worsen in June and warned of the pullback we had in the markets in July/August. While the S&P 500 recovered and went on to hit new highs, this month junk bond spreads have continued to worsen and suggest near term caution for investors.

Going forward we need to watch how junk bond mutual funds and ETFs recover. Should they stage only feeble attempts to rally in the face of extremely bearish sentiment and an extremely oversold condition, it’s quite likely the recent weakness we’ve seen is not over and a more prolonged and deeper pullback may be at work. While the junk bond market is giving the same warning signs that were seen at the 2000 and 2007 market tops, what I am seeing on the economic front tells me the weakness may be more from a loss of liquidity as the Fed winds down quantitative easing than a recession on the horizon.

Given the tendency for the junk bond market to lead at major turns in the stock market and in light of their bearish message and lack of confirming the stock market’s move to new highs, how the junk bond market reacts in the days and weeks ahead will be crucial. Should the junk market stage a tepid recovery without any real follow through, a deeper and more pronounced correction may be in the works and suggests stocks could fall further.

At past bull market tops the junk bond market turned for the worse well ahead of the stock market and warned investors willing to listen. However, the 2000 and 2007 tops were accompanied by recessions and given the lack of economic weakness and an economy showing signs of acceleration, a bull market top at this point is highly unlikely. Instead we may have the loss of market liquidity as the Fed winds down QE as a more relevant factor as those chasing higher income yields knowing the Fed was at their backs may be cashing in their chips and in search of the next yield play. How the junk bond market acts ahead will be very important and investors should listen carefully to their message for signs of the market's direction.
 
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This has been posted for Educational Purposes Only.   Do your own work and consult with Professionals before making any investment decisions. 
Past performance is not indicative of future results