There have been many themes throughout this market recovery, now
in its fifth year. The Fed's ever-present invisible hand, interest
rates that remain near historical lows, and an investor
persistently searching for higher yields are just a handful of the
many mega themes that have shaped these markets. However, with most
things in life there are usually unintended consequences, both good
and bad. One of these unintended consequences is the extreme
correlation now among most major asset classes.
This in and of itself creates a greater challenge in obtaining a
"diversified" portfolio. Some examples of this increased
correlation border on absurd such as the now much higher
correlation between European and American equity markets or the
significant connection between oil prices and equity markets.
In a few instances, though, such high correlations make more sense.
The high yield debt market is one such example, actually helping us
make more informed investment decisions.
Junk Vs. Equity
Rightly so, high yield debt, also referred to as speculative grade
or junk bonds, is very similar to its equity counterpart. Junk
SPDR Barclays Capital High Yield Bnd ETF
(NYSEARCA:JNK)) are the riskiest and generally the last of the debt
tranches to get paid during any sort of liquidation, the final rung
before equity holders. As the last tranche of debt, their bond
payments are also the last interest service paid, just before
equity dividends, so generally the risks between the two are
similar compared to other corporate debt.
All of these similarities show up in a very high rolling
correlation between equity markets and high yield bonds. When the
equity markets are up, typically so are junk bonds. When junk bonds
are down, typically so are stocks.
Given the fundamental similarities and high correlation between the
high yield and equity markets, it makes sense to notice when these
two markets are not behaving similarly, and currently JNK is not
confirming the S&P's new price highs.
Is Junk Blessing Us?
Knowing that two markets are highly correlated means we can follow
both those markets and see when one is not behaving as expected.
Knowing that these two markets should be much correlated allows us
even more comfort in that expectation, icing on the cake, so to
Looking at the chart below, JNK thus far has not made a new high
above its May levels. Meanwhile most equity markets have and that
Given the long term history of the two markets and the fact that
they eventually always confirm one another, a high probability
trade opportunity presents itself.
Buying JNK with the expectation it should do as it always has, and
confirm the S&P's new high in price is thus the play here. The
target would be a new JNK high above $41.
Is Junk Cursing Us?
However, the fact that JNK has not made a new high yet, after five
months and after two more new highs in the
(INDEXSP:.INX) is troublesome. Could junk actually be warning us?
An old saying on Wall Street is, "The bond market is smarter than
the stock market." There are a few reasons for this, but generally
it's because the bond market is so much larger and with much less
retail (i.e. dumb money) influence.
The fact that junk bonds are not leading equities higher here needs
to be noticed, as a similar setup with volatility warned us of the
September price highs.
JNK long positions need to be watched closely. If certain price
levels we are watching break down, it will be a sign that this
market top indeed is different than the previous ones as the
non-confirmation by JNK warns of another top.
Junk has been warning us since the May highs, but will it finally
bless this market's new all-time high with its own high, or will it
again curse this market's rally like it did in August and
Editor's note: This story by Chad Karnes originally appeared on
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