Downturn in High Yield Bonds Continues

On Thursday the stock market had a down day that was actually not very remarkable in terms of its extent – it was only remarkable because even such relatively middling down days have become rare these days. Another thing that made it remarkable is that there was no “obvious” trigger for the selling, which started right out of the gate.

However, as we have previously discussed, market internals have weakened all year long (see “Market Internals Are Weakening” for a recent update) and most recently we have pointed out a number of divergences that have occurred, including the long term downshift in the ratio of HYG to the SPX (see this chart). High yield debt has recently continued to weaken, after a rebound rally that appears to have failed at a lower high. Along with this event, an attempt by treasury yields to break higher seems to have failed as well:

HYG (a high yield bond ETF) suffers its biggest correction in a long time, and treasury note yields turn lower again (admittedly this may turn out to be just a brief pullback in t-note yields) 

In yesterday’s update on gold sentiment we mentioned that credit spreads continue to look gold-friendly, so here is an update of one of the proxies for credit spreads we like to use, the JNK-TLT ratio.

The ratio of JNK to TLT (high yield bond ETF vs. long-dated treasuries ETF) – as can be seen, an attempt to break back above broken support was rejected, and most recently there has been a classical “back-kiss” move 

Why is this important? In a recent comprehensive update on record issuance of questionable corporate debt we have discussed some of the reasons, but there a few things that are of direct importance to the stock market. For one thing, a lot of stock buybacks are financed by debt issuance. While much of this debt is actually of the investment grade variety, it is not completely insulated from the action in junk bonds.

Another aspect that needs to be considered are leveraged loans, which we discussed in some detail in the above mentioned update. A very large percentage of leveraged loans (issuance of which has soared into the stratosphere compared to previous asset bubble periods) are actually used in buyouts and other M&A related activity. Since leveraged loan issuance is intimately connected to the health of the junk bond market, this is a factor that has a sizable influence on demand for stocks at the margin. Consider in this context that yet another well-worn contrary indicator has just given a warning signal, namely the dollar amount of takeover deals consummated on Wall Street:

Takeovers, 12 month moving average in billions: back at the rarefied heights of the previous record established in 2007

It is noteworthy that takeover deals have “gone parabolic” this year, during the same time period when issuance of junk bonds and leveraged loans did exactly the same.

The Stock Market – A Small Decline So Far, But Weakness Underneath

There is no point in rehashing all the warning signs we have already discussed recently, but it is worth noting that the problems we have identified have not gone away, but have become worse – such as e.g. the growing performance gap between big caps and small caps. There is of course no fixed time span for which such divergences are “allowed” to last – in the late 1990s, they lasted for almost two years for instance – but the longer they do last, the bigger a red flag they become. In short, just because the market as represented by cap-weighted indexes has continued to go higher in the face of such flies in the ointment, it has not become lessrisky, but more so.

Here is a 2 year chart of the SPX that shows that the last time the index touched its 200-day moving average was in late 2012. There is also a fairly recent and quite glaring divergence with the VIX in evidence. Divergences with the VIX have often proved to be quite important signals in the past (both at lows and highs):

The SPX over the past two years – no visits of the 200 dma since 2012. Note the recent divergence between SPX and VIX – smallish divergences have occurred previously, but the most recent one is rather conspicuous 

While the SPX itself hasn’t had any meetings with its 200-dma in a long time, most NYSE listed stocks are in fact trading below their 200 dma at present. This means that there has been a “stealth bear market” underway in recent months, which the continued rise in the most watched indexes and averages has masked.

Only slightly more than 48% of all NYSE listed stocks remain above their 200-dma at present. Note how this indicator produced a glaring divergence at the recent peak, a sign that many stocks have been falling “under the cover” of the strong indexes

The percentage of SPX stocks above the 200 dma is much higher at 66%, which underscores that the market’s advance has become concentrated in fewer and fewer big cap stocks. However, even that is not a very convincing percentage:

Percentage of SPX stocks above their 200 dma. Here we see the same divergence, as well as a subtle long term deterioration 

It must be stressed that the cap-weighted indexes have barely corrected yet. The deterioration in the broader list of stocks is however a sign that at the very least a bigger correction than the small dips people have become used to in recent months may finally be beginning.

Lastly, here is an update of our Rydex sentiment chart for the stock market. We have left the annotations unchanged, because there is actually nothing new to say about it – we merely want to show where things stand. As an aside to this, the Investor’s Intelligence bear percentage has recently risen from an all time low of just above 13% to a recent 15.3%, while the bull percentage has declined from about 57.1% to a recent 47.6%.

An overview of Rydex money market funds, bear assets and the bull-bear assets ratio. The annotations we added to the chart last time around still apply

It should also be added that there has been a sizable surge in put buying in recent days, which is usually relevant as a contrary indicator in shorter term time frames. It is however still far short from the spike in put buying seen in early August.

Conclusion:

On account of the market’s uneven internals, every market dip is suspect these days. Given that there hasn’t been a sizable correction since mid 2011, we are probably way overdue for one. Note that every sizable move lower has the potential to become unruly, given near record high levels of margin debt and record negative investor net worth. In addition to the margin data we can all observe on a regular basis, there is the fact that numerous hedge funds are leveraged to their proverbial eye-brows. In fact, hedge fund leverage has surpassed its previous record high of 2007 at the beginning of the year already. Here is a brief excerpt on the topic from EWI:

“According to Eurekahedge, a global hedge fund monitoring service, hedge funds’ gross assets hit 170% of capital in January, which surpasses the previous peak of 168% in 2007.

Leverage at many of the largest hedge funds is far higher. For instance, in April, the New York Post noted that Citadel Investment Group, one of the 25 biggest US hedge funds, had implied leverage of about 8.8 times its total investment capital. The Post also noted that Citadel’s “leverage last came under scrutiny in 2008, when it had to unwind a leverage of 8.2 times as the financial crisis unfolded.”

(emphasis added)

We can only repeat what we have said before – risk remains extraordinarily high. Having said that, in late 1999/early 2000 the market actually went into a blow-off phase out of a very similar suspicious technical situation. However, we tend to think the probability of a repeat is actually low, as both the fundamental backdrop and the breadth of investor participation were quite different at the time. However, low obviously doesn’t mean non-existent. If it happens, it will be easy to recognize it for what it is though.