The east coast of the United States was not the only thing that was shaking on Tuesday. While the magnitude 5.9 earthquake caused a short and sudden jolt, the credit markets appear to be shifting in a way that might end up leaving stock investors off balance in a more sustainable way. So although stocks enjoyed an increasingly sharp rise throughout the afternoon on Tuesday, the credit markets are providing increasing signals that all may not be well.
The Preferred Stock market is one area issuing troubling signs. As mentioned in previous articles, the Preferred Stock market is an important leading indicator of underlying stress in the financial system. This area of the market was sold off sharply in early August, but then recovered to crawl back to normal levels. But over the last four trading days, we’ve seen Preferred Stocks trending steadily lower once again. This included a -0.27% decline on Tuesday on the iShares S&P U.S. Preferred Stock ETF (PFF) when the S&P 500 Index was rising +3.43%. The longer this latest downturn continues, the greater the warning sign for stocks becomes.
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The High Yield Corporate Bond market is another segment seeing challenges. High Yield also sold off precipitously in early August and managed to regain its footing to rally higher. But after peaking last Wednesday, it has also rolled over noticeably. But unlike the Preferred Stock market, High Yield was up solidly on Tuesday as measured both by the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the S&P Barclays Capital High Yield Bond ETF (JNK). A sustained breakout for High Yield above the recent downward sloping trend line would be a positive first step.
The Investment Grade Corporate Bond market is also showing some early cracks in its armor. Since early 2009 through today, the Investment Grade Corporate Bond market has performed exceptionally well as measured by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). It has remained consistently in an upward sloping trend line and continues to hold support at its 50-day and 200-day moving average. But the fact that financials make up 38% of the LQD, including 9% from European financials, puts this area of the market at risk given ongoing concerns over another global financial contagion. Some recent data trends suggest some strain may finally be affecting this area of the market.
First, Investment Grade Corporate Bond spreads have recently widened sharply relative to U.S. Treasuries. Of course, this could be attributed in part to the sharp drop in U.S. Treasury yields, as absolute effective yields are still holding generally steady.
Recent Investment Grade Corporate Bond price performance trends support the idea of trouble under the surface, however. One such example is the price performance of the LQD relative to the iShares Barclays 7-10 Year Treasury Bond ETF (IEF). These products are essentially a match from a duration perspective, as the effective duration of the LQD is 7.34 years versus the IEF at 7.38 years. Over time, it is highly unusual to see wide deviations in daily price performance between the LQD and the IEF.
When the LQD dramatically underperforms the IEF, it has often been a signal of underlying stress in the financial system. Since the inception of both products back in July 2002, both the LQD and the IEF have traded for a total of 2,284 trading days. In only 61 instances since inception has the LQD underperformed the IEF by -0.75% or more in a single trading day. A total of 43 of these instances (70%) occurred from the outbreak of the financial crisis in July 2007 to the suspension of mark-to-market accounting in April 2009. Another 6 of these instances (10%) occurred following the end of QE1 in April 2010 until the Fed began rumbling about the potential for QE2 in early July 2010. And 2 more of these instances have occurred in August 2011 as the LQD has increasingly been underperforming the IEF. This included Tuesday, with the IEF down -0.36% versus a -1.12% decline in the LQD.
Perhaps all of these recent credit market tremors will resolve themselves just as the tectonic shifts that shook the east coast quickly went away. But then again, they may be signaling that something more troubling is brewing under the surface for investment markets. If so, Tuesday’s sudden +3.4% stock market rally may prove fleeting at best, as stocks eventually start to more meaningfully react to the troubles signaled by the credit markets. Stay tuned.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
Disclosure: I am long IEF.