High-yield bonds, also known as “junk bonds,” are flashing another warning sign…
Junk bonds help to gauge investors’ appetites for risk. When junk is rallying, it’s a “risk-on” environment – and stocks tend to do well.
But when junk bonds are falling in price, investors are reducing their risks. And in this sort of “risk-off” environment, stocks tend to fall.
The good thing for traders is that the action in junk bonds tends to precede the action in the stock market by anywhere from a few days to a couple of weeks.
So, traders can use the action in junk bonds as an indicator of the future direction of stocks.
And right now, junk is looking lower. Look at this chart of the iShares iBoxx High Yield Corporate Bond ETF (HYG)…
HYG has put on a good rally since the end of December.
But recently, that rally stalled. And HYG closed Friday below its 9-day exponential moving average (EMA – red line).
Similar action in December and last August marked the start of short-term decline phases that pushed HYG lower over the next few weeks.
Here’s how the S&P 500 behaved during those selloffs in the junk bond market…
In the previous cases, the S&P 500 followed the junk bond market lower.
In December, the index dropped nearly 300 points in just two weeks. In August, we got a 300-point drop in two weeks – followed by another 300-point decline over the following month.
HYG peaked about two weeks ago. Yet the broad stock market has managed to push higher.
However, since high-yield bonds tend to lead stocks, the recent rally in the S&P 500 is on shaky ground.
Unless HYG can turn around and immediately rally back above its 9-day EMA, it’s likely headed lower to at least test its 50-day MA (blue line) as support.
If that happens, then the stock market is likely headed lower as well.
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