Mish has a post about the correlation of corporate bonds – specifically high yield corporates – with the stock market. The idea is that market participants are bidding up the prices of both risky bonds and risky stocks, even in the face of a scary rise in the junk-corporate default rate:
Inquiring minds have been asking “With Junk bonds defaults so miserable, why is the stock market rallying?” … The corporate debt market is still in control, but we now have a warning sign from treasuries yields about the strength of the so-called recovery. This rally is extremely long in the tooth, but the fact still remains: as long as corporate bonds hold up, huge equity selloffs are unlikely.
Over the last.. call it 6 months… the trend toward risk has been in full force. But a closer examination of charts suggests there is now a divergence: High yield bond prices have turned down since late July, while stocks have continued on their upward climb. To show what we mean, we sketched in an “eyeballed” trend line for each market on the charts supplied by Mish below.
If one looks at the daily chart of HYG, http://img193.imageshack.us/i/hyg.jpg/ , one could say that it is just now coming out of a consolidation which started the beginning of August, not unlike the consolidation which took place from June 15th thru July 20th. Note how the overbought status of the MACD has been worked off during this past consolidation and had a positive cross in the last two or three trading sessions. The RSI is positive and has a lot of room to move before being overbought. So one could say Junk is leading stocks “higher”. Here’s a look at a Junk mutual fund showing price rising out of the recent bollinger squeeze http://img190.imageshack.us/i/bjbhx.jpg/
So one could say Junk is leading stocks “higher”. Hmmm…could be, wonder how much higher?
I have always been a proponent that junk bonds/credit spreads leads the stock market but you have to use the open end junk funds which always trade at their NAV as opposed to the closed end or in this case an ETF such as HYG. Using the ETFs and closed end junk funds which can trade at premiums or discounts to their NAV can sometimes give a distorted picture to what is actually occurring in junkland. I’ve seen many days where the junk ETFs were slammed in response to a declining stock market yet where the open end were up because the cash junk market was firm.
Also, the charts don’t reflect the dividends paid out by the junk funds and historically since 1980 years all the total returns from junk bond funds have come from their dividends.
[...] keeping with our recent focus on the possibility that junk bonds may be signaling a decline in stocks, we present Daneric’s chart showing the possibility of an exhaustion gap in junk [...]