Stocks: No Imminent Danger, Yet

Includes: HYG, PFF, SPY
by: Eric Parnell, CFA

It has been a bumpy road for the stock market so far in the second quarter. After reaching a post crisis peak on April 2, stocks as measured by the S&P 500 Index (NYSEARCA:SPY) have declined by -4% through Tuesday's close. Given that the stock market has suffered sudden and sharp declines in 2010 and 2011 around the same time of year, this latest pullback has left investors wondering whether we are at the beginning of yet another steep correction again in 2012. Two key indicators suggest the market is in no imminent danger. At least not yet.

Stocks have certainly shown notable difficulty in recent weeks. After sustainably breaking below its 20-day moving average in early April for the first time since last November, the stock market also made a decisive move below its 50-day moving average in the last few trading days and is beginning to test an important support level at the 1350 level on the S&P 500. And given building signals of global economic weakness coupled with the latest uncertainty sparked by the election results in Europe over the weekend, reasons for worry about the stock market are certainly justified.

The current stock correction is not likely to evolve into a sharp pullback. Instead, the recent decline appears to be setting up as only a temporary setback. Two key indicators support this conclusion.

The first is the preferred stock market. Since the days leading up to the outbreak of the financial crisis back in 2008, any major breaks in the stock market were preceded by a sustained decline in the preferred stock market (NYSEARCA:PFF). This has been due to the fact that when the preferred stock market goes into decline, investor concerns have evolved from just fundamentals and valuation to more profound worries about the solvency of major financial institutions. But if the preferred stock market is holding steady, any stock market corrections have been fleeting.

Looking back at 2011 as the most recent example, stocks experienced two sustained pullbacks of -7% from mid February to mid March and -8% from early May to mid June, yet the preferred stock market held steady. It wasn't until June last year before we began to see sustained weakening in the preferred stock market, and this signaled in advance the extreme stock market turbulence that soon arrived in late July.

During the current correction that began in early April, the preferred stock market is actually up +0.4%. Thus, this suggests that the recent market turbulence is not founded in concerns about the solvency of major sovereigns or financial institutions. Of course, at least not yet.

The second key indicator to watch is the high yield bond market. Although it has been more of a coincident indicator than the preferred stock market, any major stock market correction was accompanied by a sharp pullback in high yield bonds (NYSEARCA:HYG) since the beginning of the financial crisis. This has been due in part to increased investor risk aversion amid concerns over access to financing for lower credit quality firms. But as long as the correction in the high yield bond market remains relatively shallow, any concurrent stock market declines have been limited in both duration and depth.

And once again during the current stock market correction, high yield bonds are actually trading +1.3% higher. This implies that the current stock correction is likely more about the market letting off steam with an overdue pullback. Once again, at least to this point.

Watching the preferred stock and high yield bond markets remain worthwhile in monitoring the potential depth and duration of the current stock market correction. As long as these two asset classes continue to hold up, the current stock market correction is likely to remain shallow and short lived. But with this being said, the building signs of economic weakness worldwide coupled with mounting concerns of potential contagion effects in Europe suggest that market sentiment could change swiftly to the negative at any given point in time. Such an outcome remains a distinct possibility as we move into the summer, and both the preferred stock and high yield bond markets will likely provide advance warning that such concerns are taking hold. But at least for the moment, the good news is that both of these categories are showing no signs of imminent danger for stocks.

Disclosure: I am long HYG.

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.