The S&P 500 And Dow May Be About To Fall Hard: Some Particularly Ominous Signals

 |  Includes: JNK, SDS, SPXS
by: Dave Kranzler

What's happening now is that Wall Street insiders are bailing out. It remains to be seen is they are moving ahead of a small, 5% correction or something much worse, but they see something bad coming - sourced from

The stock market and the economy are exhibiting a lot of characteristics that have coincided with abrupt and significant declines in the past. I'll review a couple technical and fundamental signals which, on their own, should cause anyone who's participated in the stock market run-up this year to take most of their money off the table. Then I'll discuss a signal that, as a former junk bond trader on Wall Street, makes me want to run for the hills.

First, to cover the fundamental side of the equation (after all, if companies can not generate operating profits, then the market value of the stock market should correct to reflect that fact) is the fact that the economic numbers over the past few months have been on the disappointing side. As an example, April core retail sales ex-autos and gas were originally reported to have increased .6% from March, but on Friday this result revised substantially lower to .2% (remember, these numbers are annualized). The revision was the result of a large-scale revision of monthly retail sales by the Commerce Department. You can survey the numbers here: Commerce Dept Retail Sales Revisions.

The revised number was below the increase of .3% expected by the market and helped fuel the market sell-off on Friday. In addition, today's ISM manufacturing index was reported to be 49, which was a sizeable miss from the 51 reading expected. A reading below 50 indicates contraction in the manufacturing sector. The new orders sub-index plunged to 48.8 from 52.3 in April. The point here is that the fundamentals which drive operating profits and cash flow appear to be deteriorating, which means at some point that fundamental investors will have to conclude that stocks are overvalued vs. the factors that drive earnings and begin to dump their shares.

Another signal that indicates to me that the stock market is potentially set up for something more than a standard price pullback is the Smart/Dumb Money Index, which is published by

(click to enlarge - chart sourced from to enlarge

This chart shows "smart" money net of "dumb" money (blue line). The smart money indicator tracks variables associated with sophisticated Wall Street investors like put/call ratios and commercial hedge positions in the futures market. The "dumb" money indicator tracks retail mutual fund flows and retail stock account activity. When the blue line above goes negative, it reflects the fact that small "dumb money" investors are very bullish relative to "smart" insider Wall Street money. As you can see, when this indicator hits a relative extreme low, it is followed by significant multi-month declines in the S&P 500.

The two examples above reflect some of many fundamental and technical signals I track that indicate to me that the stock market has become extremely overbought relative to where the stock market should trade in relation to fundamental and technical factors.

With that in mind, I want to present the high yield market indicator, which for me as a former junk bond trader, is sending a signal that not only is the stock market setting up for a price correction, but that what may occur is a massive and rapid stock market decline.

To fill in some historical context, I traded junk bonds for a big Wall Street bank from 1991-2000. It was in that capacity that I came to understand that occasional big sell-offs in the junk bond market almost always preceded big sell-offs in the stock market by 2-3 weeks. Out of nowhere, the junk bond market would start to lose its "bid side" and prices would start to decline. A day or two later, we would hear from big mutual fund accounts that they were seeing very large "hot money" redemptions. This money was typically big hedge funds that parked chunks of money in no-load junk bond funds to play upside momentum. That would be followed by several days of large mainstream institutional money outflows from the junk bond market, which precipitated big price declines. Almost every time this happened, the stock market followed a few weeks later. The most memorable time for me was when this occurred right before Long Term Capital blew up.

My point here is that the junk bond market potentially has predictive qualities that can be applied to the stock market. Today a colleague alerted me to the fact that the Barclays High Yield Bond ETF (NYSEARCA:JNK) had fallen below its 200 day moving average on Friday. It also closed slightly red today (Monday June 3rd) - despite the move higher in the stock market - after gapping down nearly 1% at the open. I had not been paying much attention to JNK recently, so I ran some performance numbers for it YTD, which then led me to look at a performance comparison chart for JNK vs. the SPX which goes back to December 2007, when JNK was issued. As you can see from this chart, the divergence between the performance of JNK and the SPX starting in October 2011 has become stunningly large:

Click to enlarge

Note that from the time the JNK ETF was issued in December 2007, through October 2011, the daily rate of return for the high yield bond market and the S&P 500 have been highly correlated, marked with a few periods of outperperformance or underperformance for the stock market. However, in October 2011, the rate of return on the SPX began to de-couple from the high yield market, to the point at which I believe the spread on the ROR between the two market segments has reached a remarkable, if not historical, disparity.

At some point soon, there will be a "regression to the mean" dynamic in which either the junk bond market will stage a big rally or the stock market will suffer a big decline. Based on several decades of market experience - and specifically based on my knowledge and experience in the junk bond market - I believe that the junk bond market is starting to price in the deteriorating economic fundamentals and has begun a price correction to reflect the expectations of higher credit risk for companies which require cash flow growth to service their debt. It is my view that the stock market will soon "catch up" to the junk bond market in a big sell-off that will be triggered soon by something - perhaps even a bad employment report this Friday.

I believe both the junk bond market and stock market are big shorts here. However, I think shorting the stock market will be the most profitable way to express this view. I like playing the leveraged inverse SPX ETFs for this purpose. SDS (NYSEARCA:SDS) is 2x inverse the return on the S&P 500 and SPXS (NYSEARCA:SPXS) is 3x inverse the SPX. Both are trading at or near their all-time lows. If you like this call and you really want to leverage your bet, both trusts have liquid options which trade. The call options will have most of the downside volatility premium removed from their price because of the mostly one-way move in higher in the stock market. I like buying volatility when it's priced cheap. Right now, I am looking at the SPXS July 11's, which went out offered today at 50 cents.

One caveat to this whole "paradigm" is if the Fed surprises the market with more QE. I think this is a very real possibility at some poin,t but probably not until the fundamentals have seriously deteriorated and the stock market has dropped a significant amount to reflect this.

Disclosure: I am long SPXS. 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.