Over the past month, while the S&P 500 has been steadily grinding higher and recording a string of new all-time highs, the junk bond sector has been quietly falling.
This divergence is important because, as we’ve often pointed out, the action in high-yield bonds tends to lead the action in the stock market.
So, if junk bonds are breaking down, then the stock market is likely to follow.
And, this week, junk bonds just fired a warning shot…
Take a look at this chart of the iShares iBoxx High Yield Corporate Bond ETF (HYG)…
On Tuesday, the right blue arrow shows how HYG closed decisively below the support of its 50-day moving average (MA) line. That has happened two other times this year marked by the two previous arrows.
Following each of those times, HYG continued lower. And, the weak action in junk bonds spilled over into the stock market.
Look at this chart of the S&P 500…
The blue circles mark where the S&P 500 fell 10% last September, and where it lost just over 4% during the decline in February/March.
So far, though, the stock market doesn’t seem to notice the weakness in HYG. The S&P 500 is sitting at its highest point ever, while junk bonds are starting to break down.
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Something has to give here. Either the strength in the stock market is going to pull high-yield bonds back up, or the weakness in junk bonds is going to pull the stock market down.
My bet is on the latter…
We’re entering a seasonally weak period for the stock market. Investor sentiment (a contrary indicator) is overly bullish. The level of speculative activity is getting out of hand.
And, investors have become so well-trained to “buy the dip” that the stock market has gone more than 200 trading days without experiencing even a 5% correction – when we normally see two such corrections each year.
We’re overdue for some downside action in the stock market. And, it seems to me the junk bond sector is signaling that a correction is coming soon.
Best regards and good trading,
Jeff Clark
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