The Junk Debt Dilemma and the Summer Crash of 2011

 |  Includes: IEF, JNK, SPY, XLP, XLU, XLV
by: Michael A. Gayed, CFA

Been quite a busy week for me but I wanted to publish another piece here on SeekingAlpha further making the case for a summer crash. On June 8th I published an article titled "The Summer Crash of 2011, or the Great Re-Adjustment," in which I argued that markets were on the verge of a possible crash given 1) the stunning outperformance of defensive sectors such as Utilities (NYSEARCA:XLU), Consumer Staples (NYSEARCA:XLP), and Healthcare (NYSEARCA:XLV) in a "bull market," 2) the message of the bond markets' low yields despite the Fed's ending of its QE2 program, and 3) that the Bond/Stock Ratio should be significantly higher as a result.

Let's look at another reason why equities markets may suffer a much more serious decline than might otherwise be anticipated. Take a look below at the price ratio of the SPDR High Yield Bond ETF (NYSEARCA:JNK) relative to the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/JNK is outperforming (up more/down less) the denominator/IEF.

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Notice that the ratio has been trending downward since mid-March of this year. What this means is that the spread between Junk Debt and Treasuries has been increasing in recent months, resulting in credit stress starting to creep back into the debt markets. Further, when that ratio trends lower (when junk-treasury yield spreads widen), it does not bode well for equities.

Something more sinister has begun to occur though. Take a look below at the intraday price action of the S&P 500 and Junk Debt.

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JNK is the bottom chart. Notice how on the 16th of June there was an outsized decline that occurred. Junk debt since recovered, but then went through another mini crack on the 22nd. This is very important to pay attention to. Why? Well let's take a look at May 6th – the Flash Crash of last year.

Again, SPY on top, JNK on bottom. The above is a 1 minute chart. Junk debt crashed before the S&P 500 crashed. If you want to understand what caused the massive decline in stocks on May 6th, you have to first understand what happened to junk debt before.

My point in all this? Keep watching the performance of Junk debt – we may be seeing the whites of the eyes of that "Summer Crash of 2011" I keep bringing up.

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