Will Junk Bond Weakness Collapse The Stock Market?

Despite doubts about the future of tax reform, the major indices have been little changed in the last two weeks. The SP 500 (SPX) and the Dow have traded in a narrow, lateral range since the start of November as Wall Street tries to discern the most likely outcome of the ongoing attempts at tax reform. Instead of equities, the bond market has borne the brunt of traders’ uncertainty over the future of the corporate tax landscape. In this commentary we’ll examine corporate bonds with an emphasis on high-yield (junk) debt. I’ll also offer an answer to the question of whether the weakness in the junk bond market will negatively impact the equity market.

As mentioned, the Senate’s version of a tax reform bill which was released last week has created some doubts in the market about the GOP’s ability to implement a tax overhaul, as it differs from the House’s version of a tax reform bill in several key areas. Conspicuously, the Senate’s version calls for delaying a cut in the corporate tax rate by one year. While equities haven’t suffered much from this disappointment, corporate bonds have evidently borne the brunt of investors’ displeasure with the Senate’s reluctance to aggressively pursue tax reform. Here’s what the Dow Jones Corporate Bond Index looks like as of Nov. 10.

Chart created by Clif Droke

Weakness in blue chip corporate bonds often precedes weakness in the stock market, so we’ll definitely need to remain on alert in the coming days. I recommend cutting loose laggards in stock portfolios and tightening stop losses on active trading positions. I’m also not recommending any new trading positions be initiated until the internal condition of the NYSE broad market shows improvement.

As of Friday, four of the six major indices – namely the Dow 30, the Russell 2000, the NYSE Composite, and SP 400 Midcap – are below the 15-day moving average on a weekly closing basis. This technical confirms an immediate-term sell signal per the rules of our technical trading discipline. While this signal doesn’t concern the overall state of the intermediate-term bull market, it’s enough to let us know that the immediate-term (1-4 week) outlook is currently showing enough weakness to warrant a more defensive posture right now.

Source: www.BigCharts.com

Underscoring the weakening internal condition of the broad market is the following graph. This shows the short-term directional (blue line) and momentum bias (red line) components of the NYSE Hi-Lo Momentum (HILMO) indicator. This indicator is based on the 52-week low new highs and new lows and is a measure of how much incremental demand there is for equities.

Chart created by Clif Droke

Right now both short-term HILMO components are declining on a daily basis, which is a sign that the short-term demand for stocks is waning. It also means that stocks are becoming increasingly vulnerable to selling pressure. I would caution that this indicator doesn’t guarantee a broad market decline is imminent, but it does increase the possibility for a pullback in the major averages. At the very least it tells us that the market is vulnerable to bad news which could be used by bears as an excuse to raid the market.

One concern among many investors right now is the marked deterioration in junk bonds in the last two weeks. The SPDR Bloomberg Barclays High Yield Bond ETF (JNK) underscores this weakness and has elicited many a bearish commentary from Internet pundits.

Source: www.BigCharts.com

In view of the fact that extended weakness in the junk bond ETF has preceded major declines in the SP 500, should investors be concerned? If the junk bond market weakness continues long enough it could indeed pose a problem for stocks, as it did in 2015. However, this time around the weakness in JNK is mainly relegated to the high-yield debt of companies in the telecommunications segment.

Among the top 10 debt holdings of the JNK include: Sprint (NYSE:S) 7.875%, CCO Holdings LLC 5.125% (parent company of Charter Communications (NASDAQ:CHTR)), and Frontier Communications Corp. (NYSE:FTR) 11%. These companies are reflective of the extreme underperformance of the telecommunications industry. Not surprisingly, many of the new 52-week lows on the NYSE right now are telecom companies. Following is the one-year graph of the Dow Jones U.S. Telecommunications Index (DJUSTL), which tells the bleak story of this industry.

Source: www.BigCharts.com

While the weakness in telecom stocks has spilled over into the junk bond market enough to cause some short-term damage, it’s doubtful it will create as much residual damage to the broad equity market as the previous junk market meltdown of 2015 did. One reason why the 2015 junk bond bear market was especially onerous for stocks is because of the extent to which high-yield energy bonds were the focus of the bear market. Energy companies have a far greater influence in the large-cap indices like the SP 500 than do telecom companies; 7.14% vs. 2.61%, according to Bespoke Investment Group.

Source: Bespoke Investment Group

What’s more, extreme weakness in crude oil prices in 2015 added to the selling pressure and contributed to some economic weakness at that time. The current weakness in telecom, by contrast, is of less consequence to the broad market and the economy. At this time the energy sector is on a much stronger footing and the price of oil is in a rising trend. Thus the junk bond market decline is less threatening vis-à-vis the junk bond bear market of 2015. Consequently, the dominant intermediate-term stock market uptrend should remain intact despite rumblings from the realm of high-yield debt.

It’s also worth mentioning that the high-yield debt meltdown of 2015 was accompanied by a rally in short-term Treasury bonds and blue chip corporate bond prices. This was due to the “flight to safety” among investors as T-bonds became the vehicle of choice of the safety conscious. This time around there’s no such evidence of a flight to safety as even Treasury prices have been declining recently along with Dow Jones corporate bonds. Note the chart of the iShares 3-7 Year Treasury Bond ETF (IEI) below, which is at a seven-month low. This would not be the case if investors were worried about a broad market meltdown.

Source: www.BigCharts.com

The latest decline in the junk bond market is likely a combination of telecom industry specific weakness as well as perhaps investors’ concern that the interest rate outlook is no longer conducive to being heavily long junk bonds. Despite the possibility of some short-term spillover weakness in the NYSE broad market, the decline in the high-yield debt market isn’t likely to spoil the long-term bull market in equities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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