Already stocks have had a volatile fall, but it could get even worse.
That’s because a change in the bond market is pointing to a sharp decline in stocks unless something changes, according to one analyst.
The reason why savvy investors watch the bond market is that buyers of fixed-income securities, as bonds are known, tend to be far smarter than their stock investor counterparts. At least, that’s what many Wall Street professionals have told me repeatedly.
“If we want to know how real money is flowing in and out of real assets, we need to watch the biggest market of them all: Bonds,” writes J.C. Parets, founder of AllStarCharts and an expert in so-called technical analysis, or chartism.
What’s happening is that investors are ditching junk bonds, also known as high-yield securities. These are bonds that are sold by companies with less than stellar credit ratings.
Parets continues with an explanation of how things work:
When institutional money wants to be aggressive, they position themselves into riskier, higher yielding junk bonds at a faster rate than they do into more conservative, lower yielding U.S. Treasury Bonds. If there is stress and they need to be getting more defensive, you’ll see that flow into Treasuries at a much faster rate than into riskier Junk.
What he has noticed is that when credit spreads decline, then the market tends to head higher. The credit spread measures how much more a junk-rated company must pay to borrow money than does the U.S. government. He also looks at the ratio of the price of iShares iBoxx $ High Yield Corp Bond ETF (ticker: HYG) to iShares 20+ Year Treasury Bond (TLT).
When the ratio declines, then the spreads are widening, and stocks tend to fall shortly afterward. Spreads widened at the start of the financial crisis, and then stocks dropped like a stone. Parets has also seen other similar instances in the last few years when stocks declined after the ratio of the ETF prices fell.
Recently high-yield spreads have been rising. The spread on the ICE BofAML US High Yield Master II Option-Adjusted Spread jumped to 3.84 percentage points on October 29, up from 3.16 percentage points on October 3, according to data from the St. Louis Federal Reserve. That might sound like a small move, but in these things it is the direction that matters. Widening spreads are also indicative of investors ditching the securities.
That’s why Parets is worried about a repeat of a stock market drop.
If we don’t get a miracle recovery back above the early 2017 highs, stocks are incredibly vulnerable and much lower prices are likely.
In this case, he is referring to a recovery in the ratio — that is to say an increasing ratio or a decline in the credit spreads.
The obvious point that many people may make is that the economy is looking so strong so how could such a thing happen?
Remember that the stock market and the economy are like cousins. They are related but not the same. You can have a strong economy and a sliding market at the same time.
When the stock market tumbled in October 1987, the U.S. economy was doing exceptionally well. The market soon recovered, and the economy continued growing for years.