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Why Stock Investors Should Care What Happens In Junk Bond Market

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    October 5, 2014

    Perhaps the biggest news story of late is that Bill Gross (AKA: the “Bond King”), founder of PIMCO and the largest bond fund in the world, is leaving to join Janus Capital. Shares of Janus (JNS) surged more than 40% on the news while PIMCO’s parent company, Allianz, fell more than 8%. While Gross’s departure may have garnered most of the headlines , there were other significant moves in the bond market that caught lesser attention—the second biggest outflow in high yield bonds (“junk bonds”) since the bull market began five years ago.

    Of the top 10 fixed income exchange traded funds (ETFs) with the most redemptions this year, both the number one and number two highest were high yield funds. The iShare iBoxx $ High Yield (HYG) fund takes the top spot witnessing over $2.5B in outflows this year, which equates to 16.9% of the fund’s total assets. The SPDR Barclays High Yield Bond ETF (JNK) lost over $1B in redemptions, which is 11.6% of total fund assets.

    mutual funds
    Source: Bloomberg

    Investors have been in such a frenzy to reduce their exposure to high yield that net sales of high yield mutual funds have fallen to their lowest level since June of last year and the second lowest level since the bull market began in 2009. As shown below, whenever we see large outflows form high yield in a short time frame that tends to spell capitulation and lead to an oversold rally in the space.

    ici mutual fund flows
    Source: Bloomberg

    More signs for a relief rally coming from the high yield space is the bullish divergence between the price of HYG and its fund flows. From the fall of 2013 through June of this year investors were dumping their investment in HYG all the while the fund kept marching higher. This meant investors were using the market strength to exit their positions and warned the high yield space was on shaky ground (red shaded region below).

    The high yield space then began to capture investor headlines as high yield funds like HYG and JNK saw large redemptions and significant declines. There was a temporary bottom in HYG in August before the fund hit a recent new low, but what I want to point out is that the high yield space may have fallen too far too fast. I say that as I noticed we saw less redemptions on the recent decline than we did heading into the August bottom (see green shaded region) and suggests the pool of investors willing to flee the high yield space may be drying up and we could see another bottom in the sector.

    high yield
    Source: Bloomberg

    For investors in the stock market what happens next in junk bonds will be crucial ahead since they often lead the stock market at important turns. For any doubters out there a simple history lesson over the last two bull markets will make this abundantly clear.

    A look at the 2000 market top into 2003 is a good case of this as equity investors could have saved themselves a lot of pain by listening into the developments of the junk bond market. For example, credit spreads in the junk bond world (shown inverted in red below) began to deteriorate nearly a year before the S&P 500 peaked late in 2000 (see red bar) and warned of coming trouble. Similarly, while both spreads and the stock market put in a bottom late in 2002, the stock market sold off again into the spring of 2003 while junk bond spreads significantly improved and hinted that stock investors had it wrong and correctly called the bottom.

    junk bonds
    Source: Bloomberg

    Following the script of 2000 and 2003, the message from the junk bond market correctly warned of a top and bottom in 2007 and 2009. By the middle of 2007, junk bond spreads began to deteriorate while the S&P 500 marched to a new high in October of 2007 (red shaded region) and warned all was not well in the financial markets. Similarly, spreads reached their nadir late in 2008 and staged a strong recovery and yet the stock market sold off and hit a new low in March 2009 before bottoming (green shaded region). Anyone listening to the junk bond market late in 2008 and 2009 may have ignored the financial press that the end of the world was upon us and could have snatched up stocks at cheap valuations.

    junk bonds
    Source: Bloomberg

    Because of the tendency of the junk bond market to warn of significant turns in the stock market ahead of time, I constantly check in on their message and junk bonds are not singing a happy tune. Spreads began to worsen in June and warned of the pullback we had in the markets in July/August. While the S&P 500 recovered and went on to hit new highs, this month junk bond spreads have continued to worsen and suggest near term caution for investors.

    high yield junk
    Source: Bloomberg

    What needs to be watched intently in the weeks ahead are incoming economic data as well as watching key support levels for the markets. Should the markets sell off and incoming economic data sour, we may be in store for a deeper retrenchment than what has been witnessed so far.

    As highlighted above, mutual fund redemptions and ETF outflows are reaching the highest levels seen since the 2009 bull market began and suggests we’ve seen near-term selling capitulation. In addition, looking at breadth data from the Russell 3000, which covers roughly 98% of the entire US market capitalization, shows we’ve seen selling intensity reach levels that’s often associated with intermediate-term lows and a relief rally may be under way.

    russell 3000
    Source: Bloomberg

    Going forward we need to watch how junk bond mutual funds and ETFs recover. Should they stage only feeble attempts to rally in the face of extremely bearish sentiment and an extremely oversold condition, it’s quite likely the recent weakness we’ve seen is not over and a more prolonged and deeper pullback may be at work. While the junk bond market is giving the same warning signs that were seen at the 2000 and 2007 market tops, what I am seeing on the economic front tells me the weakness may be more from a loss of liquidity as the Fed winds down quantitative easing than a recession on the horizon. For example, typically before the onset of a recession we see the Philly Fed’s State Leading Index for the United States dip below 0.5% and a recession often starts and ends around the 0% line. At the current 1.57% reading we are near the upper range of readings seen over the last decade and well away from warning levels (orange line) and well away from a recessionary signal (red dotted line).

    philly fed
    Source: Bloomberg

    In fact, there are signs the economy is still accelerating as GDP for Q2 was revised higher yet again to a 4.6% annualized rate and looking at recent readings from the ISM Non-Manufacturing Index (Service Index) that lead GDP shows GDP growth for Q3 may be even higher. The recent reading of 59.6 was the highest reading in nearly a decade and suggests GDP growth continues to accelerate from present levels.

    ism manufacturing
    Source: Bloomberg


    While Bill Gross is capturing headlines today, what carries far greater significance to the market is the action in the junk bond markets. Someone in the space yelled fire at the start of the year and investors have been heading for the exits. It was only until June before junk bond spreads and prices for junk bond ETFs began to worsen. The selling appears to have reached a feverish pitch and smells of capitulation in the near term and a relief rally may soon develop. We also have a stock market that is deeply oversold when looking at breadth indicators and next week may see a recovery into the end of the third quarter.

    Given the tendency for the junk bond market to lead at major turns in the stock market and in light of their bearish message and lack of confirming the stock market’s move to new highs, how the junk bond market reacts in the days and weeks ahead will be crucial. Should the junk market stage a tepid recovery without any real follow through, a deeper and more pronounced correction may be in the works and suggests stocks could fall further.

    At past bull market tops the junk bond market turned for the worse well ahead of the stock market and warned investors willing to listen. However, the 2000 and 2007 tops were accompanied by recessions and given the lack of economic weakness and an economy showing signs of acceleration, a bull market top at this point is highly unlikely. Instead we may have the loss of market liquidity as the Fed winds down QE as a more relevant factor as those chasing higher income yields knowing the Fed was at their backs may be cashing in their chips and in search of the next yield play. How the junk bond market acts ahead will be very important and investors should listen carefully to their message for signs of the market’s direction.

    Images: via Flickr (licence attribution)

    About The Author – Chris Puplava, Financial Sense Online

    Chris graduated magna cum laude with a B.S. in Biochemistry from California Polytechnic State University, San Luis Obispo. He joined PFS Group in 2005 and is currently pursuing the designation of Chartered Financial Analyst. His professional designations include FINRA Series 7 and Series 66 Uniform Combined State Law Exam. He manages PFS Group’s Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account. Chris also contributes articles and Market Observations to Financial Sense and co-authors In the Know—a weekly communication for Jim Puplava’s clients only—with other members of the trading staff. Chris enjoys the outdoors.


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