One Man’s Junk

Because the bond market is so large in comparison to the stock market, it can be worth monitoring for clues as to what may be in store for stocks. That might seem counterintuitive but stocks are simply a measure of investor’s appetite for risk. Within the bond market, junk (high yield) bonds take on the same role.  As such, junk bond prices normally move in unison with stocks. When they diverge, like they did last week, should give investors a hint that something may be afoot.

In the upper pane of my chart below is a plot of SP500 price (in red) and the junk bond ETF, JNK, in blue. The bottom pane is a smoothed correlation coefficient of the two investments, which has hovered near 1 (perfect correlation) for most of the past year.  As you can see that while the movements can vary in the size of the movement, the direction is almost always in the same direction. That is except for two times which I have identified within the purple ellipses. The first time being last April when stocks fell briefly while junk bonds rose. The second being the last few weeks as junk bonds have fallen substantially while stocks continue to rise.

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All divergences, this one included, are warning signs to investors that something (or someone in this case) is wrong. The question one has to ask is, is it the bond investors or stock investors who have it wrong.  Are stocks ready to follow junk bonds lower? Or is this just another example of market makers playing games with junk bonds and it eventually turns out to be a wonderful buying opportunity?  The answer to these and other questions will only be known in the rear view mirror but until then the divergences should be viewed as a cautionary yellow flag for investors.