Two Indicators of Risk Appetite Suggest Trouble Ahead for Stocks

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As regular readers are probably aware, my background is in the interbank foreign exchange market. I learned many important lessons in dealing rooms around the world, but what I believe to be the most useful was an understanding of the importance of capital flows, and how to interpret them.

The main use of that analysis is to assess the appetite for risk among the fund managers who control the big money, and right now two indicators that I follow are indicating that that appetite is dwindling.

It should be said that markets are, by nature, unpredictable and not even the smart money is right all the time, but when those with access to the world’s best research seem to be leaning in one direction it generally pays to take notice. Over the last couple of weeks, that smart money has been moving away from one risky market that generally performs well when the economic outlook is good and into another, much more defensive area.

High yield, or junk bonds tend to thrive in good times. The yield on a bond is a measure of the perceived credit worthiness of the issuer, so high yield bonds are generally those issued by companies whose credit rating is below investment grade. If there are expectations for a strong economy with robust growth that is not felt to be a problem and the additional yield that can be gained by buying junk bonds is worth the added risk.

When investors see some weakness coming, however, high yield is one of the first things jettisoned to dial down the risk profile of a portfolio.

With that in mind, take a look at the above chart for the SPDR Bloomberg Barclays High Yield ETF (JNK) above. The drop since the middle of last month is not huge, but the fact that it is an acceleration of a longer-term trend lends it more significance. Even so, in what is expected to be a rising interest rate environment that would put downward pressure on bonds in general, that alone would not be cause for worry were it not for other evidence of a quiet move towards a “risk-off” trade.

Utilities are the ultimate defensive stocks. Individuals and businesses consume power whatever the state of the economy and power companies generally pay high dividends, so they are a good place to hide and generate a return if there is an expectation of weakness in the broader market.

That makes this second chart, for the SPDR Utilities Sector ETF (XLU) somewhat worrying.

One could argue that the jump in XLU is not a warning sign at all but rather a technical retracement of the big drop in the sector that started at the end of last year, but two things suggest otherwise. The first is that the low on that drop was hit back in February so the timeline negates the idea that this is a retracement in the technical sense.

In addition, this surge has come even as we draw nearer to two expected rate hikes. Because dividends make up such a large part of the intrinsic value of utility stocks, rising rates make them relatively less attractive as compared to bonds, so one would normally expect them to drop, or at least stay depressed as rate hikes approach.

Both the move down in high yield and the move up in utilities, then, are hard to explain as anything other than a sign that investors are de-risking, and the fact that they are occurring at the same time makes that even more of a logical conclusion.

It is far too early in those moves to panic, but both indicators should be watched closely. If they continue to suggest a risk-off environment, then trimming stock positions on rallies and/or hedging your portfolio in some way would make sense.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Economy , Bonds , ETFs , Investing Ideas , Stocks , US Markets
Referenced Symbols: JNK , XLU

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Martin Tillier

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