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Bond Market Screaming That Stocks are Toast

Thursday, August 13, 2015
Money and Markets
YOUR BEST SOURCE FOR THE UNBIASED MARKET COMMENTARY YOU WON’T GET FROM WALL STREET
You can also access this issue on our website.
The Bond Market is Screaming That Stocks are Toast ... Should You Listen?
Market Roundup
Dow +5.74 to 17,408.25
S&P -2.66 to 2,083.39
NASDAQ -10.83 to 5,033.56
10-YR Yield +0.059 to 2.189%
Gold -$8.90 to $1,114.70
Oil -$1.07 to $42.23

By Mike Larson

You know what the bond market is saying, or rather, screaming? That the stock market is toast!

Take a look at this chart. It shows the relative performance of the SPDR Barclays High Yield Bond ETF (JNK) versus the SPDR S&P 500 ETF Trust (SPY)

SP2a (JNK in red.)

One pattern should be blatantly obvious to you: High-yield (or “junk”) bond prices and stock prices are generally linked at the hip. And that makes sense when you think about it. After all, both stocks and junk bonds are risky bets on a company’s prospects.

If the company’s earnings and sales grow nicely, its stock price rises and its ability to service its debt rises, too. So that leads to corresponding gains in junk bond prices. The opposite occurs when fundamentals deteriorate.

If anything, I’ve learned over the years that bond investors tend to be a bit smarter than stock jockeys. So you’ll often see declines in junk bond prices before you’ll see declines in stock prices. Or in other words, deterioration in the junk bond market is a solid “leading indicator” for the stock market.

That’s why charts like these worry the heck out of me. JNK just sank to a three-year low. As a matter of fact, it’s all the way back to a level it first traded up and through back in September 2009.

Its sister ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), doesn’t look much better. Yet the major stock averages are paying little heed, down just a few percentage points from their recent highs.

If you look at the spread, or difference, between junk bond yields and underlying Treasuries, you see much the same story. Spreads are rising sharply amid increased fears of credit losses. We’re back to levels we haven’t seen since late 2012 – as you can see in this chart of a benchmark spread index produced by BofA Merrill Lynch.

(research.stlousfed.org) (research.stlouisfed.org)

Do you know what the Dow Jones Industrial Average traded at in late 2012? Around 13,000 — 4,400 points below current levels. The S&P 500 went for 1,400, give or take a few points. That’s almost 700 points below current levels, or around a third cheaper.

Now I’m not saying stocks have to crash hundreds or thousands of points overnight. And I’ll be the first to admit this divergence has persisted for some time. The typical bullish pundit on CNBC will also tell you the junk bond weakness stems entirely from problems in the energy sector, so it doesn’t “matter” for the broad averages.

Me? That sounds a lot like rationalization and excuse-making to me. It’s a lot like what I heard in 2006-2007, when we saw early signs of stress in the credit markets, too. The bulls said it was all because of mortgages and housing, so you could ignore it. But we know how that panned out.

Bottom line: The bond market is speaking loudly, saying that stock investors are in for rough seas. That doesn’t guarantee the averages are going to tank. But it sure as heck should have you concerned about that possibility.

So if you haven’t taken those protective steps I’ve been highlighting lately, I’ll ask again: What are you waiting for? The worst case is you end up forgoing some upside potential, and you just buy back in later. The best case is you raise cash and put profits in the bank before the stock market lemmings catch on.

Now it’s your turn. Do you watch the bond market, and does the recent action have you concerned about stocks? Do you think we can excuse the action because a significant chunk of the weakness is related to weakness in energy? Or do you think that’s a dangerous line of thinking, particularly with problems popping up in all kinds of other commodities and emerging markets? Let me know what you’re thinking over at the Money and Markets website.

Our Readers Speak

The stock market, the Chinese currency and Obamacare were just a few of the topics you were discussing online in the last day.

Reader H.C.B. offered the following take on China’s latest moves: “China is just compensating for the accomplished fact their currency has already appreciated quite a bit in the past year, effectively. China is just doing Janet Yellen’s job for her, but on their terms.

“We are becoming less relevant in the world every day when we let foreign countries take away our initiative and let them make the changes on their terms. We no longer lead. The next president won’t likely change this imbedded trend as it reflects our collective views and attitudes (apathy).”

But Reader Mike S. noted that China is still very dependent on the U.S., no matter how much the country may protest otherwise. His view:

“Think the Chinese are in control? Wait until the average American decides that they are NOT going to buy anything made in China! Yea, I know it will take a while for America to retool. But if the Chinese screw around too much, they are very likely going to get themselves a huge reaction from the biggest consuming nation in the world.”

As for the impact of China’s moves on the markets, Reader Gary said: “It seems more and more financial bloggers are predicting a collapse in markets and currencies. I think it is more about fear than economic reality and that we will continue to muddle along until governments get out of the way and let smaller businesses compete.”

On the other hand, Reader Frank said the writing is on the wall already when it comes to markets. His take: “On the stock market, the 50 day moving average just crossed over the 200 day moving average. Just another of many things saying this market is about ready to roll over.”

Lastly, Reader Richard G. weighed in on the decline in uninsured Americans with this thought: “Obamacare is not good insurance, with its high deductibles and copays. The cheapest plan has a $6,000 deductible . The users of Obamacare can’t afford that.

“Medicaid would have been better. All it did was increase persons ‘with insurance’ (statistical games). Exchanges (unfunded mandate) are losing money. That raises rates for all of us who have real insurance.”

I appreciate all the feedback, and hope you keep it coming. We managed to rally off the lows yesterday, which is a sign to me that true capitulatory panic hasn’t taken place yet.

Plus, as I wrote today, stock investors seem to be whistling past the graveyard when it comes to the message emanating from the bond market. That’s a dangerous thing to do, historically speaking. So I’m not sure we’ve seen the worst of this correction/pullback/possible collapse.

Any other thoughts? Then be sure to post them here.

Other Developments of the Day

BulletOfficials from China’s central bank tried to defend the yuan’s value at a rare press conference in Beijing overnight. They said there was no basis for further depreciation. Vice Governor Yi Gang also said China wasn’t trying to bolster exports by depreciating its currency. But traders ignored the comments, selling the yuan again anyway.

There’s a lesson here, one I’ve learned in my almost two decades of following markets and central bankers. Forget what officials say. Watch what they do if you want to be successful. After all, Baghdad Bob also said in Gulf War II that there were no American tanks in Iraq’s capital city … even as you could hear them rumbling down the street in the background.

BulletSpeaking of China, huge explosions rocked the port city of Tianjin on Wednesday night – explosions caught on multiple scary videos posted online. They went off at a hazardous cargo storage lot, killing at least 44, injuring hundreds, blowing out windows as far as a mile away, and laying waste to a wide swath of goods, cars, and shipping containers.

BulletTesla Motors (TSLA) announced plans to sell another 2.1 million shares worth $500 million as part of its factory expansion plans. The company is bleeding red ink like mad, forcing it to sell billions of dollars worth of shares and debt to fund operations. But CEO Elon Musk still believes his company could be profitable … by 2020.

BulletDonald Trump. Bernie Sanders. Ben Carson. They aren’t exactly the mainstream candidates that tend to win elections, particularly a presidential one. But that’s also why they’re surging in popularity, according to this Washington Post story.

The reason? Americans are fed up with bought-and-paid-for, special interest-funded candidates spoon feeding them the typical claptrap, rather than actually getting things done in D.C. Definitely a trend that bears watching, though many political pundits believe candidates like Trump will ultimately flame out.

So do you think a true Washington outsider like Trump or Sanders is what this country needs? What about Tesla’s ongoing losses – do they make the stock uninvestable or do you think all this capital raising will pay off with big profits down the road? And how about China’s latest currency comments? Truth or fiction? Let me hear about it at the website.

Until next time,

Mike Larson

Mike Larson
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

For more information and archived issues, visit www.moneyandmarkets.com.

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