It’s Better to Carry an Umbrella and Not Need It…

Storm clouds are forming over the junk bond market. That’s another caution sign for stocks.

“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 like it’s ready to turn lower. Look at this chart of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG)…

The action over the past few weeks has created a “rising wedge” pattern on the chart. This is a bearish pattern that often breaks to the downside.

In addition, while HYG has been moving higher the momentum indicators at the bottom of the chart have been moving lower. This sort of “negative divergence” is often an early warning sign of an impending decline.

The last time HYG had a similar setup was in late February. Back then, HYG broke the rising wedge pattern to the downside. That action coincided with a sharp drop in the broad stock market.

Of course, we’ve looked at lots of caution signs lately here in Market Minute. So far, the broad stock market has ignored all of them. The S&P 500 is trading near its highest level ever.

So, I’m feeling a bit like the Miami weatherman who spots a wisp of condensation over the Atlantic Ocean and thinks, “hurricane.”

I’m running the risk of being overly cautious.

But, at this stage in the market cycle, and at this spot on the calendar, it’s better to carry an umbrella and not need it, than to need an umbrella and not have one.

Best regards and good trading,

Jeff Clark
Editor, Market Minute