The Dichotomy Between Junk Bonds And Stocks Continues

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Includes: ACP, AIF, ANGL, ARDC, BIL, BSJP, CIF, CIK, CJNK, DDM, DFVL, DFVS, DHY, DIA, DLBS, DOG, DSU, DTUL, DTUS, DTYL, DTYS, DXD, EAD, EDV, EEH, EGF, EPS, EQL, FALN, FEX, FIBR, FWDD, GBIL, GGM, GOVT, GSY, HIX, HUSV, HYDB, HYDD, HYG, HYIH, HYLB, HYLD, HYLS, HYT, HYUP, HYXE, IEF, IEI, ITE, IVH, IVV, IWL, IWM, JHML, JKD, JNK, JQC, JSD, KIO, MCI, MPV, NHS, OTPIX, PCF, PHT, PLW, PSQ, PST, QID, QLD, QQEW, QQQ, QQQE, QQXT, RISE, RSP, RWM, RYARX, RYRSX, SCAP, SCHO, SCHR, SCHX, SDOW, SDS, SFLA, SH, SHV, SHY, SJB, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TNA, TQQQ, TTT, TUZ, TWM, TYBS, TYD, TYNS, TYO, TZA, UBT, UDOW, UDPIX, UJB, UPRO, URTY, USHY, UST, UWM, VFINX, VGIT, VGLT, VGSH, VLT, VOO, VTWO, VUSTX, VV, WFHY, ZROZ
by: Ivan Martchev
Summary

Junk bonds 'read like a bond but trade like a stock'.

As the most volatile sector of the bond market, they offer significant opportunities to either make or lose a lot of money.

The stock market decline last quarter appeared to be predicting problems that the junk bond market did not (and still does not) see.

Mike Lanier, who has spent over 35 years in the trenches of the bond market, told me a while back that junk bonds “read like a bond but trade like a stock.” As the most volatile sector of the bond market, they offer significant opportunities to either make or lose a lot of money. The siren song of their much-higher yields only goes so far, as this is the price that must be offered for their much-lower credit quality.

Because of their volatility and intricacies between individual issues, it is my opinion that most individual investors should not buy and hold junk bonds, yet most investors should keep major ETFs and index spreads on their radar screen as they offer valuable insights on the prospects of the economy and stock market. Typically, the prospects of the economy and the stock market are intertwined, but as Nobel Prize laureate Paul Samuelson famously said in 1966, “The stock market has forecast nine of the last five recessions.” We appear to be in one of those famed dichotomies at present, as the stock market decline last quarter appeared to be predicting problems that the junk bond market did not (and still does not) see.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Many investors don't know that there is a heavy correlation between an index like the S&P 500 and a broad junk bond ETF like Barclays High-Yield Bond (NYSEARCA:JNK) or HYG. While the S&P 500’s rebound off the horrific Christmas Eve lows at the end of 2018 has certainly been impressive, the rebound in junk bond prices has been even more so. The JNK ETF is today where it was when the S&P 500 was near 2,800. For the sake of argument, if one were to use JNK as an indicator – and no single indicator should be used as a master key – one could reasonably expect another 200-point rally in the S&P 500, wiping out most of the fourth-quarter losses – i.e., those that were not driven by a deteriorating economy.

In hindsight, these fourth-quarter losses in stocks were driven by 1) Federal Reserve overzealousness, 2) White House Twitter feed attacks on the Fed, 3) Mueller and other investigative bombshells, and 4) the trade negotiations. The minute we saw positive headlines on some of those fronts, and a notable change of tone by the Fed and the White House, the stock market and the junk bond market staged a big rebound.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In the vast majority of cases, the junk bond market tends to lead the stock market before big sell-offs and most certainly before major tops, but not this time. I looked at how junk bond spreads were performing 3-4 weeks into the 4Q sell-off in the stock market and I saw that the “junkier” the junk bonds were, the tighter the credit spreads. That told me that it was not an economic problem that was driving the selling.

I have said many times that sharp sell-offs in a good economy tend to reverse themselves. Some reverse themselves very fast, like in 1998, while others take some time, like in 1987. The stock market went down better than 20% in those cases but those weren't real bear markets. The fact that junk bonds are now rebounding quite a bit more vigorously than stocks is a positive sign for the stock market.

A real bear market would be characterized by a grinding decline that takes its time due to shrinking EPS for a major index like the S&P 500. Last time I checked, for all of 2018, companies are expected to report EPS growth of over 20% and revenue growth of 8.8%. For all of 2019, analysts are projecting earnings growth of 6.9% and revenue growth of 5.5%. Those projections have been aggressively cut in the last three months, but they are still positive and the economy is still expanding.

It’s the Market (before the Economy), Stupid!

As earnings season approaches, is it possible that a lot of companies are getting too pessimistic in their earnings guidance because of the downdraft in the stock market? Could they be thinking that falling stocks – as well as December’s experience with impossible-to-issue leveraged loans and junk bonds – mean a weaker economy? It sure is. In the brave new world of quantitative easing, it was the stock and bond markets that pulled the economy out of a recession, as QE inflated assets prices. Now, quantitative tightening (QT) is deflating asset prices. The question is: Can QT push the stock market and the junk bond market sharply lower, and can such declines cause a recession themselves?

In other words, in the brave new world of quantitative tightening, is the tail wagging the dog?

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In theory, draconian QT policies by the Fed can create a crash in the stock market, as well as the junk bond market, contributing to a recession. The Fed has the power to crash the economy by increasing the suction rate of excess reserves and thus removing large amounts of electronic cash from the financial system. I don't believe they want to do that, but in theory, they can, if they want to.

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Over 20 years ago, one of my favorite graduate school finance professors told the class on multiple occasions that he thought the Fed Chairman (then Alan Greenspan) had more power than the President of the United States (Bill Clinton at the time). I was still a rookie and found it easy to dismiss his rather bombastic statement, but after more than 20 years in the trenches of the fascinating world of finance, I have come around 180 degrees on the issue. The trouble is: Being Fed Chair is an unelected position.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.