If you follow the bond market, you may be familiar with the saying: “Bond guys catch things before stock guys do.” That means the credit market often waves “yellow flags” before problems reach the stock market.
Investors are looking for clues for caution after the S&P 500 last week posted its biggest decline since 2012. Anxiety has spiked as the benchmark index has fallen 3.4 percent this year after soaring 32 percent in 2013. A number of factors are at play: The Federal Reserve is withdrawing its stimulus, emerging economies are slowing, U.S. corporate profit growth is lackluster. Yet the American economy is showing signs of strength as manufacturing and housing rebound.
|If you’re a stock investor, it pays to follow the bond market, if only to know when to get defensive.|
Here’s how to cut through the clutter. First, the bond market focuses on only two major issues:
1. How much does a bond pay?
2. What are the odds of a default?
When the market determines the probability of a bond default, it includes an assessment of the economy.
If the odds of a recession are low, then the odds of widespread bond defaults also are low.
Conversely, if the odds of a recession are high, the odds of bond defaults begin to increase.
If you believe the odds of widespread bond defaults are low, then you would prefer to own a bond that pays a higher yield.
If you believe the odds of bond defaults are rising, then you would prefer to own a higher-rated and more conservative bond.
Credit Market Foreshadowing
The meat of the chart below shows the performance of higher-yielding, riskier junk bonds (symbol: JNK) relative to the aggregate bond market (AGG).
The S&P 500 is shown for reference purposes.
When the JNK/AGG ratio is rising, it tells us the market would rather chase yield, since it is not too concerned about bond defaults.
When the JNK/AGG ratio falls, it tells us demand for riskier junk bonds is decreasing due to increasing concerns about getting paid back.
The JNK/AGG ratio was in an established downtrend (lower high, lower low) before the S&P 500 dropped 18 percent between points A and B, meaning it was helpful in terms of reducing exposure to stocks.
What Is the Credit Market Saying Now?
The JNK/AGG ratio looks much less concerning today than it did in 2011.
The current rising trend tells us in 2014, so far, the market would rather chase yield, since it is not too concerned about bond defaults.
If the ratio morphs into something that looks like the first chart, our concerns about the U.S. stock market would increase.
But remember: If you’re a stock investor, it pays to follow the bond market, if only to know when to get defensive.