High Yield Diverging from US Stocks

The S&P500 inched up another 0.67% last week. Volatility slipped a little, which is what one would expect in an up week.

The technical picture became more bleak, especially for the Dow Jones Industrials.  For the first time since 2011, the Dow experienced a “Death Cross” where the 50 day moving average crossed below the 200 day moving average. Back in 2011 this led to a total loss of about 20% and in 2008, this led to a total loss of over 50%. The key point is that this development almost always suggests that a bear market correction will follow.

At the same time, the Death Cross has not yet happened in the S&P500, and until it does, most market analysts will not declare an end to the bull market. Why? Because the S&P500 is far more important to market experts that the Dow Jones Industrial Average. That said, the 50 day moving average in the S&P is still converging ominously to the 200 day, and the Death Cross looks like an imminent and strong possibility.

While we’ve highlighted some key market divergences lately (eg. oil, copper, and other commodities), and while these bearish divergences have continued to worsen (ie. oil and copper have continued to fall while the S&P500 has continued to hold up), another very interesting divergence has been occurring in the high yield market.  Back in July, tracking funds such as HYG experienced a Death Cross of their own.  HYG’s 50 day is now below its 200 day moving average.  And this development is extremely ominous for equities. Almost every time in the past when HYG (or its equivalent) diverged bearishly from US equities, the divergence resolved itself with equities falling to match the drop in high yield credit. In other words, the smarter money seems to be in high yield bonds, and it “gets out” of its positions well before the dumber money in stocks gets out.

And this historical relationship is so strong, that it’s highly likely that the same thing will happen again this time. Of course, this doesn’t mean that stocks must crash to resolve the divergence. But they will need to fall far more than the 2-3% that they’ve fallen this year, whenever they’ve dipped. Instead, a drop of at least 10% and possibly 20% would correct the divergence.

For so long, over the past two to three years, US stocks have magically held onto big gains, and have even piled more gains on top of their prior gains. At the same time, almost all other risk asset classes have broken down and have suffered meaningful corrections. However, stocks’ magical price gains will not last forever.

 

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