Over the past three months, global equity markets around the world have been in rally mode as investors have responded positively to new measures from the ECB and Fed. However, despite the action from global central bankers, the high yield bond market has not responded.
In a previous piece published on July 9, when the Dow Jones Industrial Average (DIA) was trading at 12,750, I discussed the confirmation signs the high yield bond market was sending equity investors. The confirmation turned out to be accurate as stocks have continued to moved higher since July. However, currently, as shown by the chart below, the high yield bond market is not confirming the recent rally.
The high yield bond market, represented by SPDR Barclays Capital High Yield Bond ETF (JNK), has failed to confirm the recent rally. Over the past three months, as shown by the chart above, the high yield bond market has only risen slightly while the stock market has made a more substantial move
As shown by the chart below, the spread between the S&P 500, represented by SPDR S&P 500 ETF (SPY), and JNK continues to widen.
It should be noted, as shown by the chart below, over the medium term, it would have been smart to buy stocks when the high yield market was keeping pace with the stock market or outperforming and it would have been smart to sell when the stock market was outperforming the high yield market.
What Does It Mean?
The recent divergence between the high yield bond market and stock market is a ominous sign for the stock market. The current situation is ominous because, in the past, when the high yield bond market has failed to keep pace with the stock market, a short term decline in equity prices has usually occurred. However, the divergence is not enough to be completely bearish on equities. Rather, I would continue to watch the correlation as an indicator. It might make sense for short term traders to lighten up long exposure here, and look to re-enter stocks on a pull-back. That being said, for long term investors I would not suggest selling as this relationship has been more of a short term indicator than a long term indicator. I would become more bullish if the stock market pulls back and the high yield bond market remains firm. Weakness in the high yield bond market, not just underperformance, would make me more bearish on equities than I currently am.