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Technical Update: Junk Bonds Breaking Down.

  • Written by Syndicated Publisher 41 Comments41 Comments Comments
    October 27, 2011

    I feel like I am in a slow motion car wreck. I see what’s coming yet time stands still. I scream to my passengers yet they don’t hear me.

    These markets are surreal to say the least. They make no sense on the surface. Regardless of news, lack of volume, lack of broad participation they just go higher. Which brings me to possibly my least favorite Wall Street adage “Trade what you see not what you think.”

    I understand the concept, don’t bias your eyes if you will. If the market is clearly going one direction don’t fight it. But perhaps traders need to “look” a little deeper. Perhaps studying tick for tick price is comparable to a pilot flying while looking out the window, ignoring what the instruments tell him. It may look clear but how much visibility do you really have.

    So rather than look out the window today to see if any obstacles are in our flight path, let’s look at the gauges.

    Follow the junk

    This chart has been discussed a number of times now yet it is very simple and has worked in all market selloffs since May 2. The simpler the tool in my view the more useful.

    What we have right now is a massive divergence. Bigger than that of early August when the markets corrected over 250 SPX handles. Perhaps this indicator will no longer work but how could anyone ignore it. In simplest terms it is telling us that risk has been stretched to an extreme. History has also taught us that everything eventually reverts to the mean.

    That is until the junk is breaking down

    Now take a closer look at the junk. Look at the divergence forming between HYG (iShares High Yield Bond fund) and JNK (SPDR High Yield ETF).

    Too complicated for you?

    Alright then let’s keep it really simple. Let’s go back to the poker game example discussed on Tuesday.

    Europe has been bluffing for weeks, convincing many that their hand is solid. Convincing many to fold. Today they literally showed their hand. After weeks and weeks of meetings and rumors well past the IMF imposed deadline they come up with nothing. An old rumor that China will invest in the EFSF. No concrete plans on anything yet Rome continues to burn “literally.”

    The head of China’s sovereign wealth fund already said they would not help. He already called Europeans lazy. Brazil has already said no to further aid. This summit couldn’t even produce an agreement on how much Greek debt will be written down. It produced nothing but hope (and remember what they say about hope and trading).

    Meanwhile back to Rome is burning. Banks are liquidating. They are racing to raise cash to meet capital calls, customer withdrawal demands, offset lack of short term financing. The European economy is sliding into recession as yet again leaders feel to realize how their inaction holds the economy hostage. Their inaction and lack of leadership freezes credit markets which go well beyond the banking system.

    So you are sitting at that table. The vast majority have folded. Europe is staring you in the face. What do you do?

    Personally, I put my cards down on the table. I stare back at them and say “let’s see what you got. I’m going no where. And oh by the way, look out for those mountains due east.”

    Images: Flickr (licence attribution)

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