Warning from High Yield Bonds

The S&P500 kept the party going last week. The index managed to rise another percent on even lower weekly volume. Volatility dipped slightly, but notably, it hasn’t returned to the ultra-complacent levels seen during the summer months when the S&P itself traded at lower levels. So while the overall index is at all-time highs right now, many investors are a bit more nervous about whether these highs can be maintained.

The technicals point to a US stock market that’s over-stretched. Actually, it’s ridiculously over-stretched….with the S&P500 climbing from its mid-October lows without dropping below its 5 day moving average since that time. This is a very unusual pattern for stocks to follow, even for stock markets in traditional bull markets.

The US economic releases, last week, painted the typical unimpressive picture. Industrial production disappointed. So did housing starts. Initial jobless claims came in worse than expected. PMI manufacturing and the Empire State manufacturing survey both missed expectations. At the same time, the Philly Fed beat consensus estimates. Existing home sales climbed at bit and leading indicators (pumped up directly by the rising stock market) also beat expectations. All in all, there is still no organic, self-sustaining economic recovery for much of America–specifically for Main Street Americans.

While US stock markets set new record highs last week, an interesting divergence was logged in the high yield credit markets. For the first time since the near 20% sell-off in the S&P in 2011, the junk (or high yield) market—as measured by the HYG ETF—registered a negative divergence.  Its 50 day moving average crossed below its 200 day moving average.

When this last happened in mid-2011, the S&P500 went on to lose almost 20%….but only after this event happened in HYG.  This suggests that the smarter money was in high yield bonds and that it led the general equity markets by dropping before the stock markets corrected.

So if the something similar were to happen this time, then now is the time to lighten up on your equity positions. While this credit market did lead the equity markets, the lag time was minimal.

So the alarm bell is going off right now.  High yield money is scared and stock market investors should take note.

US Treasury Rates

US equities virtually stalled their upward progress last week, with the S&P500 inching up only .39% on very light volume. Countering the slight move higher in prices, stock market volatility bumped upward…with the VIX index creeping a bit higher by the end of the week.

Since the bungee jump rebound started several weeks ago, this past week’s results suggest that the move may be stalling—-because the rise in prices has been decreasing in percentage terms every week, with last week’s rise being the smallest.

This leaves the US stock markets on the edge of big precipice—by recovering all of the October losses, and then some, the S&P500 has now rapidly returned to overbought and overstretched conditions last seen only at other dangerous times—1927, 2000, and 2007 being among them. Of course, as usual, today’s similar condition does not guarantee that a crash is around the corner, but it does guarantee that future returns will be lower (because prices have shot up so far and so fast already, there’s less room for them to keep rising at the same rate) and that there’s more downside risk than there was before the boomerang rebound (when prices fell 10%, they have—by definition—less room to fall further, because they’re that much close to the ground).

On the economic front, there’s really nothing very good to report. Initial jobless claims came in slightly worse than expected. Job openings (in the JOLTS survey) were lower than hoped for. Retail sales were just a bit better than predicted, as was consumer sentiment but that was only because future expectations jumped (current conditions were perceived to be horrible).

We’ve been spotlighting US interest rates, specifically the rate on the US 10 year note, for almost a year now. And the trade that has worked so well over this entire time keeps on working….with no end in sight.

Last year, when the 10 year touched 3.0% and 100 out of 100 economists surveyed by Bloomberg predicted that rates would rise to 3.25%-4.0% by the end of 2014, we saw things differently.

In an economy that’s not truly recovering, this rate had no business rising; in fact, it should be dropping.

And drop it did, first to the upper 2 percent range, then to the mid 2’s, and then to the lower 2% range, and on October 15th it touched 1.87%!

Today, it has rebounded back up a bit, to the 2.3% range, which is miles away from where ALL the “experts” predicted it would be this time of year.

So where will it go now?

Based on the same analysis that worked for us over the last 12 months, the rate on the 10 year should drop again, even from 2.3% where is sits today.

To be more precise, a return to, or even below, 1.87% should be considered very possible.

A catalyst for such a move would be another equity market sell-off (ala the one we saw in early October) which would drive scared money into US Treasuries….the same way it did in mid-October.

And since the S&P now sits at all-time highs again, this could be a good time to think about initiating this Treasury trade….again!

US Stocks—Overstretched….Again

Once again, the S&P500 marched upward, and once again, on declining volume. This week, the S&P rose by almost 0.7%. And volatility dipped slightly—slightly only because it had already dropped by quite a bit over the previous two weeks.

Amid this incredible boomerang in US stocks, the US economic reports mostly disappointed. PMI manufacturing, for example, missed expectations. Construction spending collapsed, when it was instead expected to rise. International trade missed badly. ISM services also disappointed. For the week, only ISM manufacturing and factory orders beat expectations, and even then, only slightly. The big number of the week—payrolls—missed. Fewer jobs were created than experts had predicted. And average hourly earnings rose by half the amount expected. Meanwhile, the labor force participation rate remains stuck at multi-decade lows….which means that the US labor markets are still a disaster.

So after going into a mini free-fall in October, US stocks boomeranged right back to where they started—at former record highs and actually a bit beyond.

So now, stock prices sit right back where they started in late September, at extremely overstretched levels….once again. And as history shows, over and over again, when prices are so severely overstretched, bad things tend to happen, as they did in mid October, when prices went into a short-term free-fall.

This begs the question—is another sell-off similar sell-off about to hit US stock markets? And the answer is that they are once again extremely vulnerable to another sell-off, but that this severely overstretched condition does not guarantee that they will sell off in the short run.

What the extreme overvaluation does guarantee however, as John Hussman so clearly points out in his newsletters, is that anyone who buys or owns stocks at these prices should expect to realize a future return—-from today’s prices—-that is far below historical stock returns.

Why? The logic (and the historical data supporting it) is quite simple—if you pay a super high price for stocks now, you should expect a super low return over your future holding period.

This simple, yet very easy to forget, principle has never failed to work over the entire history of US stock prices….a span of time that exceeds 100 years.

What makes it easy to forget is that almost all investors seem to forget the lessons of history…..usually as the stock markets make,and continue to make, new highs. Most everyone begins to believe that “this time is different”, when in the end, when a market cycle finally completes itself (by the way, we are currently only in the first half of the cycle—the bull market that started after the bear market lows were reached in 2009), it’s never different.

This market has another cycle ahead of it. Eventually, the bear market that always follows the bull market will begin. And only after this bear market ends, can investors finally determine if they’ve made money—by measuring gains and losses over a complete, bull and bear, market cycle.

 

The Fed Ends QE, but the BOJ Steps In

Finally, after well over a year of printing over a trillion dollars in new money, the Fed has terminated its latest open-ended QE program. So how did the market respond—not so badly. More on why below.  The S&P500 rose 2.7% in another strong push higher on top of the huge rise in the prior week. Volatility fell back down to complacent levels, as measured by the VIX index. But volume was light—meaning, once again, this rise can be construed much more as a short-squeeze than as a wave of investors jumping back into US stocks.

In the real economy, meanwhile, things are not so exuberant. Last week, durable goods orders fell—-instead of rising as expected. And even when the volatile transportation orders are removed, orders fell instead of rising as expected. In housing, the Case-Shiller index of home prices missed expectations….prices went up a bit, but far less than experts predicted. Jobless claims were a bit worse than expected. Personal income and personal spending both missed badly, so folks are making less and spending less. And finally, the PMI services flash index also missed. On the positive side, the Dallas and Richmond Fed surveys beat expectations. Consumer confidence, surprisingly given the figures on spending and income, rose a lot. And finally, Chicago PMI beat consensus estimates.

In terms of technical analysis, the S&P500 has now jumped so far and so fast, in these past two weeks, that it’s once again seriously overbought on the daily charts. Prices have returned back up to the upper Bollinger band. In terms of trend and bull market status, the 50 day moving average—while pinching in toward the 200 day moving average—has not come close to crossing below the 200 day moving average. Also, the slope of the 200 day moving average is still rising. Until, both of these indicators change, there is no bear market.

Finally, a note on what happened last week in stock markets. Within a day of the Fed announcing the end of its QE program, the Bank of Japan announced—stunningly—a massive new QE program of its own. While this is considered a huge act of desperation by the Japanese central bank (and this is a long story by itself), the program created big spillover effects, so big that the minute the Japanese program was announced, US stock futures roared forward and haven’t looked back since. Well at least so far.

Whether this is just a short-term knee jerk reaction in the US markets remains to be seen. In the meantime, all the underlying problems in the US economy (and for that matter, in most of the world’s large regional economies—Europe, Asia, Latin America, etc.) have not been fixed.

Everyone, to the extent they realize this, is simply betting that until the equity party ends, they must be dancing on the dance floor. Everyone believes—that when the music ends….as it always has in the past—they will be able to escape off the dance floor and out of the room before any true selling panic begins. To whom will all these “savvy” investors sell their overpriced stocks when that moment arrives?  Good question.