High Yield vs. US Treasuries

“What’s with this market? Is the economy going to crash? Why are we raising rates? What is going on with my stocks!?” I’ve heard these questions be asked, rather shouted, throughout the month of December - from 401(k) account holders, news addicts, traders and at times, even myself (though I hate to admit it). The answer to these questions does not consist of some eloquent explanation, depicting a fundamental breakdown in our economy. The answer is actually quite simple. Stocks go up and stocks go down. When a market is overbought and upside potential is overwhelmingly limited relative to downside risk, participants sell.

S&P 500 Futures 1D Chart

We saw this is January, as an extremely overbought market began selling off. We saw it again in October, as a failed breakout led by the Russell 2000 Small Caps, erased gains from Q2’s bullish summer run up to all-time-highs. Now in December, after a two month consolidation period, US stocks broke key support and are in the beginnings of what looks like a classic bear retracement. The financial media love to put a cause behind any movement in the market. They’ll blame rate hikes, White House foreign trade policy, and of course the infamous “Algos”. In reality, yes systematic risk does play a role in the day to day volatility of the stock market, but does it really change the overall picture? I don’t believe so, and I don’t think any active participant should either. I’d much rather focus on the evidential trend revealing itself through price movement.

With 2018 nearly in the rear view mirror, I find it important to run through Q4 sector / sub-sector performance. The below table displays both Quarter-to-date and Year-to-date returns. Of the funds listed, Q4’s biggest laggards include Energy, Biotech, Aerospace & Defense and Retail . While the best performers of Q4 are Gold, Utilities and Long-term Treasury Bonds

iShares High Yield Corporate Bond ETF (HYG) was hit hard this quarter falling -4.48% despite the Fed hiking rates another 25 bps in December. If we have a moderately hawkish Fed, shouldn’t high yield bond funds be performing well relative to long-term treasuries? This does not appear to be the case, as junk bond yields continue to tread higher, leaving prices in the dust. The below chart is SPDR High Yield Bond ETF (JNK) vs. iShares 20+ Year Treasury Bond ETF (TLT). The false breakout we saw in early October, gave wind to a steep downward move below an 11 year resistance trend line.

I’ve put together the below to help us visualize the correlation between the S&P 500 and when Junk is under-performing US Treasuries. This supports the bear case for US stocks - historically when we see a bounce off the resistance trend line in JNK vs. TLT (and the chart proceeds to downtrend) - we see negative or nominal returns in the overall market.

S&P 500 Total Return adjusted for Inflation (Dividends are not reinvested)

June 2008 to March 2009: -42% return

February 2011 to May 2012: -2.32% return

January 2014 - January 2016: 3.94% return

This does not mean the two are perfectly correlated; when it comes to credit, there are many factors to take into consideration. I just felt it important to make note that despite interest rate hikes, US Treasury Bond prices (which carry the highest interest rate risk due to their longer maturity) are treading higher, while Junk (high yield) bond prices continue to tread lower. This may indicate that investors are softening their view of a hawkish Fed. It also signals that despite a strong economy - we can still have a bear market in stocks. All in all what I personally take away from this, is not that Junk bonds under-performing will send our stock market down the tubes, rather it will weigh on stocks and cause additional volatility and uncertainty in the coming year.

Before I close this month’s newsletter I’d like to take a look at Gold futures. The below is a 1W chart of Gold Futures (COMEX: Current Contract).

  • The 50 weekly moving average is currently above the 200 weekly moving average.

  • Chart is coiling and building up substantial volume

  • Room to run on the Relative Strength Index

  • Resistance at 1400 an ounce

Gold is often used as a hedge against systemic risk, and in Q4 it has performed extremely well against the broader market. Up over 7% QTD, as price continues to coil we can expect a big directional move in the coming months. The direction of said move, I have not a clue.

Thank you all for reading - See you in 2019.