Got junk?

My friend Brooke Thackray writes a newsletter that ties his macro technical views into seasonal plays. Brooke, for those who don’t know him, is one of the original people in Canada to study seasonal trends. In fact, I met Brooke some 20 years ago after I read his first book – Time In – Time Out. I had commented on that book in an article I wrote for Canadian MoneySaver way back then, and Brooke took the time to call me and thank me for the reference to his book. We’ve been in touch ever since.

Brooke’s recent newsletter looks at three things on the stock market to watch as potential leading indicators should the current bull market decide to weaken. He asks the reader to keep an eye on the relative performance vs. the S&P 500 of:

• the semiconductors,
• the technology sector (related sectors, yet worth watching independently)
• the ratio of junk bonds vs. quality bonds. You can read the entire analysis on Brooks newsletter here –and you can subscribe to it for free if you like the info.

Today, I thought I would copy/paste some of Brooke’s analysis surrounding the two bond markets. I’ll include the chart that he included in his newsletter. From there, I decided (being the curious type that I am) to look at the relationship of the two bond markets froma a longer perspective. I applied a correlation study to the two of them – from which I’ll provide you with a little of my own input after Brooke’s words. Lets get started with Brooke’s observations:

Junk bond performance relative to investment grade bonds

The third canary is the relative performance between the junk bond (high yield) sector compared to the investment grade corporate sector. The junk bond sector is more sensitive to deteriorating economic conditions as the sector has a higher probability of having defaults. When the junk bond sector is outperforming, it generally means that investors are bullish in the stock market (not always). The bond market is huge: it dwarfs the stock market in size. There is an adage that bond investors know best. Currently, junk bonds are underperforming investment grade bonds, which is an indication that bond investors believe that the economy is faltering. This canary is starting to “tweet,” that there is trouble ahead and investors would be wise to pay attention.

Junk bonds have been underperforming investment grade bonds for some time. They have already issued their warning. Bond investors are not buying this rally. Using relative bond performance does not provide a timing indicator as divergence with the stock market can persist for quite some time. Best to consider this “canary” as a warning sign.

My observations

Below is a longer chart of the JNK  ETF (black line) vs LQD ETF (red line). The lower pane on the chart is a correlation line. Most of the time, the two are correlated in performance. Periodically, the relationship changes. When that happens (black boxes – where the correlation drops well into the negative), it appears that it can give warning that volatility may be coming to either of them. The orange line on the chart is the SPX. You will note some greater volatility on the SPX during those “black box” periods. This, especially, when the correlation line stayed negative for a prolonged period of time over 2015.

All in, it’s a data point. Something to keep an eye on.