Another Reason to Be Cautious

High-yield bonds are flashing a warning sign.

“Junk bonds,” as high-yield corporate debt is often called, help gauge investors’ appetites for risk. When junk rallies, it’s a “risk-on” environment – and stocks tend to do well.

But when junk bonds fall in price, investors reduce their risks. And in this sort of “risk-off” environment, stocks tend to fall.

The good thing for traders is that the action in junk bonds tends to precede the action in the stock market by anywhere from a few days to a couple of weeks.

So, traders can use the action in junk bonds to indicate the future direction of stocks.

And right now, junk is looking lower. Look at this chart of the iShares iBoxx High Yield Corporate Bond ETF (HYG)…

HYG has put on a good rally since the end of October. Of course, that “risk-on” action has coincided with a record-breaking rally in the stock market.

But HYG has been struggling for the past few weeks. It is trading below the all-time high it posted in December. The blue line shows that HYG recently closed below its 9-day exponential moving average (EMA).

The red arrows on the chart point to previous times when HYG closed decisively below its 9-day EMA.

Is the Stock Market Headed Lower?

Here’s how the S&P 500 behaved during those selloffs in the junk bond market…

In four of the five previous cases, the S&P 500 followed the junk bond market lower.

Last February, for example, the index dropped nearly 300 points in just four weeks. In August, we got a 200-point drop in two weeks – followed by a nearly 400-point decline in September.

HYG peaked about four weeks ago. Yet the broad stock market has managed to push higher.

However, since high-yield bonds tend to lead stocks, the recent rally in the S&P 500 is on shaky ground.

Unless HYG can turn around and immediately rally back above its 9-day EMA, it’s headed lower. If that happens, the stock market will likely be headed lower as well.

Best regards and good trading,

Jeff Clark
Editor, Market Minute