September 19, 2013
Chad Karnes, Chief Market Strategist
In case you didn't get the memo; modern portfolio theory has blown up.
Almost all asset classes are now extremely highly correlated, which is a very new thing. Have you noticed that when stocks rise, commodities are also up? When the Euro is up, the U.S. stock market is also up? When the housing market jumps, so do other assets. Even when bonds are rallying, so are stocks. Energy (NYSEARCA:XLE), financial (NYSEARCA:XLF), health care (NYSEARCA:XLV), European (NYSEARCA:VGK), and even Japanese (NYSEARCA:EWJ) stocks all rise and fall together, much more so than historically. You get the picture.
Correlations across asset classes in reality are at all time highs, and in my article entitled, “Are Rising Correlations a Threat to Your Portfolio?” I touched the surface on the new world we live in and showed that correlations are at levels never before seen.
This alone presents great risks for a “diversified” portfolio, but how can we can use this new world disorder to our advantage?
What does Junk have to do with it?
If there is one investment category that does belong in the same discussion as “highly correlated” with equities, it is junk bonds. These types of high risk bonds behave and act more like equities than any other bond class.
Junk bonds, or if you prefer the more socially acceptable description, “high yield debt”, are typically the final tranches of debt a company takes out. They are the last debt pieces to get paid back during times of distress and the first tranches to default. Because of this increased risk, speculative grade debt pays higher yields than more secure and safer trances.
The latest estimates by S&P put the speculative grade bond market around $2.2 trillion in size, which makes this market much larger than most would likely assume. Based on S&P’s junk classification this includes all bonds that have a rating of BB+ (or Ba1 for Moody’s). However, junk still remains just a small slice of the total U.S. bond market which is around $37 trillion (compared to a U.S. equity market (NYSEARCA:VTI) around $22 trillion).
Junk bonds historically have always been highly correlated with equities. Because of this historical relationship we can use high yield debt (NYSEARCA:HYG) price movements compared to equity price movements to find warning signs, red flags, and trade setups.
The best way to see the junk (NYSEARCA:JNK) and the equity markets' (NYSEARCA:SPY) high correlations along with some potential trading signals is by perusing some historical charts.
The first chart below shows the five year history of the ETFs that track the S&P 500 (SNP:^GPSC) and the high yield bond market (NYSEARCA:JNK).
Notice the extremely high correlation through time? That shows that JNK and SPY (NYSEARCA:SPY) price movements behave very similar through time, sometimes approaching identical.
It also shows that whenever correlation dips near zero (prices are behaving differently), it eventually bounces back, approaching 1.0 (prices are behaving almost identically).
Bonds are Smarter
An old saying on Wall Street is that the bond market is smarter than the equity markets. Two of the reasons for this are because it simply is much larger and thus more scrutinized. Also, the bond market has very few direct retail buyers.
WATCH: Ignore the VIX to Your Own Peril
As mentioned above, the bond market (NYSEARCA:BND) is over 50% larger than the equities market in asset value. But given that bonds are also reissued every few years on average and stocks typically are not, the turnover value of the bond market is exponentially larger than the equities market. New issues of bonds are issued daily, whereas new companies going public are weeks or months in between. The bond market (NYSEARCA:BOND) simply dwarfs the equities market.
The equity market also is a secondary market where buyers and sellers of all kinds exchange shares. The bond market however has very few retail investors participating directly in it. Because of this the bond market it is said to be more trustworthy.
For these and other reasons we turn to the bond market (NYSEARCA:AGG) for the smarter, or “correct” signals of the two.
Recent Junk Signals
Looking at the junk bond market’s signals more recently and shown by the next chart analysis, there were some telling signs warning of the recent short term equity peas.
During the equity markets’ May topping process, Junk had already peaked and turned down two weeks earlier.
Again in July, the junk debt market peaked two weeks before the equity markets.
These two peaks in the junk market warned of weakness to come in the equity markets.
Today junk remains in a downtrend, making 2 lower highs with one today testing that downtrend as shown in red on the chart.
This is occurring as stocks are making new highs.
If JNK continues higher, it will confirm the breakout in equities. However, if JNK stays below its July peak, it will again warn that the equity market rally will likely be short lived as JNK has been warning since May that the uptrend is not as strong as equities suggest.
There are also a few other ways to take advantage of the high correlation and warning that high yield debt is currently sending the equity markets including a market neutral pairs trade and other ways to take advantage of a continued rally in JNK. I follow these and other trade setups in our twice weekly Technical Forecast.
The ETF Profit Strategy Newsletter and Technical Forecast use technical, sentiment, and fundamental analysis to stay ahead of the markets. Right now the smarter bond market does not trust the equity rally since May, and it may be warning us again that this renewed equity rally will be short lived.
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