High Yield Credit Divergence

The S&P500 fell almost 1.4% last week on moderate volume. This loss reversed most of the gain booked the week before. Examining volume in more detail, we saw that it spiked the most on the day that the equity markets fell the most; and volume fell on days when prices rose. To repeat, this is not a sign of a strong bull market. Volatility jumped almost 23% as measured by the VIX index; but this is to be expected when prices slip.

In terms of technical analysis, prices broke below the 50 day moving average on the S&P. While they later recovered a bit to close above, this is a violation of an uptrend, and this break will raise concerns among all technical traders. On the daily charts, prices have retreated just a bit from their upper Bollinger band; the same has happened on the weekly charts. So while  the S&P is not quite as overbought as they were two weeks ago, they are still only a couple of percentage points away from their all-time highs. Meanwhile, breadth continues to deteriorate—for example, at no time during 2014 were fewer stocks above their respective 150 day moving averages than at the close of trading on Friday. Not good.

At the same time, the US economy is still inching forward very, very slowly, and this is despite the $3.5 trillion created by the Federal Reserve since 2008 to save the financial system and the US economy. Certainly, the US financial system has been “saved”; the US economy, not so much.

In specific news, the Chicago Fed national activity index plunged, instead of growing as expected by economists. Existing home sales dropped, also, instead of rising as expected. The house price index disappointed. The PMI manufacturing index also disappointed. Durable goods orders missed—both headline and without transportation. Also, the Kansas City fed manufacturing index missed expectations. On the positive side, only new home sales and initial jobless claims beat consensus estimates.

Last week, we noted that while the S&P500 was creeping up to new all-time highs, that the Russell 2000 was not only dropping but showing a small loss for the year. This. we concluded, was a serious bearish divergence that should put all equity investors on alert.

This week, another serious bearish divergence must be noted. While the S&P500 continues to hover only a couple of percentage points away from all-time highs, the high yield credit market has recorded some serious losses over the last several weeks. And not only have high yield prices (eg. on the ETF HYG) broken below the 50 day moving average, but the 50 day moving average is sloping downward and about to slice below the 200 day moving average—this is better known as the Death Cross, a very important technical indicator that often marks the start of a bear market.

Why does high yield matter to the stock markets? Because both markets trade in risky assets, they are usually highly correlated. And since high yield is breaking bad, this becomes a strong force on equities to follow along. Once again, we’ll know in a few short weeks if stocks do in fact follow high yield down in price, or if somehow, high yield reverses course and rockets up to join its stock market cousin.

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