Market Outlook: Another Troubling Sign For Stocks

by: Eric Parnell, CFA

The U.S. stock market continues to push along steadily to the upside. Not only are stocks firmly established in a long-term uptrend, but they also appear to have room to continue higher into the near-term. Overall, the performance of the U.S. stock market remains most impressive. Unfortunately, stocks are increasingly traveling this upside path alone, as many other major global markets and asset classes that are highly correlated with stocks have either already ground to a halt if not turned lower beginning as long as two years ago. The longer this disconnect lasts and the more stocks move higher by themselves, the greater the probability that U.S. stocks will finally succumb and fall in line with the rest of the crowd. And one of the latest categories to fall off the upside path is high yield bonds, which is particularly troubling since it is not only among the categories most closely related to U.S. stocks, but it also opens up a tangled web of related issues to consider.

U.S. stocks (NYSEARCA:SPY) and high yield bonds (NYSEARCA:HYG) are highly correlated with one another. This might be surprising, as the word "bonds" in the name high yield bonds can lead some to believe that the asset class behaves more like U.S. Treasuries than stocks. But the exact opposite is true. For example, high yield bonds have a strong weekly returns correlation with stocks over the last five years of +0.75 while having a negative weekly returns correlation with long-term U.S. Treasuries (NYSEARCA:TLT) of -0.24 over the same time period. In other words, when stocks are going up, high yield bonds are also usually going up, while U.S. Treasuries are commonly going down at the same time.

The recent deviation in returns between U.S. stocks and high yield bonds is therefore troubling for those expecting the equity rally to continue into the long-term. To put this historical relationship into perspective, both U.S. stocks and high yield bonds had been almost perfectly correlated since the beginning of 2009. Whenever U.S. stocks began to move ahead of high yield bonds, they quickly retreated back in line. And whenever stocks began to fall behind, they quickly caught back up. That is until we entered into 2013, for since the beginning of the year, U.S. stocks and high yield bonds have deviated dramatically. While high yield bonds are virtually flat year-to-date, the U.S. stock market has soared.

Now a natural explanation to the recent deviation between U.S. stocks and high yield bonds could be the following: how low could we really expect the effective yield on high yield bonds to go? In recent months, yields had fallen toward the 5%. To put this reading into context, the previous all-time low yield for the asset class had been 6.9% back in December 2004. Looking at this reading another way, the interest rate on the 3-month U.S. Treasury bill, which is considered by many to be the "risk-free rate" was higher than the current yields on high yield bonds as recently as 2006. Thus, one might conclude that high yield bonds may had simply reached their limit in their ability to continue moving higher, while stocks may be otherwise unconstrained in this regard.

But a problem quickly presents itself with this conclusion. For it is not just about the effective yield for high yield bonds. Instead, the spread between high yield bonds and comparably dated U.S. Treasuries is just as important if not more so. And when viewing high yield bonds on an option adjusted spread basis, we see that the current reading for the asset class at over 4.5% is still well above the historical low readings near 2.5% from the mid-to-late 1990s and again from 2004 to 2007. This implies that high yield bonds still have considerable room to move to the upside on a spread basis.

Of course, a strong counterpoint can easily be made against the spreads argument in support of high yield bonds. One might conclude that the only reason that high yield spreads are relatively higher today is because U.S. Treasury yields are so low. And as Treasury yields rise as they have sharply since early May, this spread has the potential to quickly narrow. In other words, the risk premium investors are receiving for owning high yield bonds instead of comparably dated Treasuries could quickly evaporate with Treasury yields rising even if high yield bonds don't move an inch. Thus, high yield bonds are no longer moving higher along with stocks for good reason given these risks specific to the bond asset class.

The problem with higher interest rates, however, is that they also undermine stocks in a similar way. For example, the U.S. stock market as measured by the S&P 500 Index currently has a price-to-earnings ratio of 18.5 on an as reported basis. Inverting this number provides us with an earnings yield for the U.S. stock market of 5.41%. With the 10-year U.S. Treasury yield currently at 2.61%, this implies a premium that investors are getting paid for owning stocks is now just +2.80%. What is notable is that this spread has fallen dramatically from the +4.25% reading at the beginning of the year when both stock valuations and Treasury yields were considerably lower. In short, investors are now getting paid quite a bit less for owning stocks versus Treasuries than they were only a few months ago.

Many would seek to diffuse any worries about the earnings yield for the stock market with the following key point: the equity risk premium for stocks had been negative for years prior to the financial crisis. Thus, the fact that it is even positive at all today makes stocks still an attractive bet.

It should be noted, however, that this conclusion is at potentially perilous risk of recency bias. For while the fact that this reading was negative from the early 1980s until just prior to the outbreak of the financial crisis is indeed true, it is also true that the equity risk premium was meaningfully positive for the 100 years prior with an average reading of nearly +4%.

This raises a key question. What is the normal equity risk premium? Is it the negative readings since the early 1980s? Or is it the positive readings prior to 1980s? Now many in our stock market focused world might conclude that the answer to this question must lie with stocks, but it does not. Instead, the bond market has determined the answer all along. This is a topic that I will be exploring in more detail in an upcoming article, but it is very possible that we may simply be returning to an environment where positive equity risk premiums will once again become the norm. If this is the case, stocks may actually be rather expensive and may continue to become even pricier if Treasury yields continue to rise.

The bottom line from all of this is the following. The reasons that high yield bonds are struggling are not likely that far removed from U.S. stocks. And the longer these two asset classes continue to diverge, the greater the pressure is likely to build on U.S. stocks, particularly if Treasury yields rise further in the months ahead as so many seem to be projecting.

For the more aggressive investor, one might consider a pair trade that includes going long high yield bonds while at the same time shorting the S&P 500 Index (NYSEARCA:SH). However, attempting to short anything related to the stock market remains a treacherous proposition as long as the monetary stimulus continues to flow.

In the meantime, stocks appear poised to continue rising at least for now. For this reason, I remain allocated to the stock market with broad exposures through positions such as U.S. large caps via the Vanguard S&P 500 ETF (NYSEARCA:VOO) and U.S. small caps (NYSEARCA:IWM) through the iShares Core S&P Small-Cap ETF (NYSEARCA:IJR). I also currently have exposure to specific sectors such as industrials (NYSEARCA:XLI), financials (NYSEARCA:XLF) and real estate (NYSEARCA:VNQ) as well as more specialized allocations such as Japan (NYSEARCA:DXJ), gold miners (NYSEARCA:GDX) and gold (NYSEARCA:GLD) via the Sprott Physical Gold Trust (NYSEARCA:PHYS). It should be noted, however, that all of the above positions are being viewed with very short time horizons and managed with tight stops given the persistent risks and heightened volatility that has the potential to present itself at any moment in time.

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 IJR, DXJ, XLI, VNQ, XLF, VOO, PHYS, GDX. 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.

Additional disclosure: Short-term holding periods are set on all current positions.

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