Is the high yield market flashing a warning sign for U.S. stocks?


Jeff Gundlach discussed his worry

The U.S. stock market and the high yield bond market typically have a strong positive correlation. This is because many junk bonds move as if they are stocks. This means that the U.S. stock market and high yields are typically inverse.
There has been a big divergence in 2017 between high yield bonds and the S&P 500. This is a warning sign for the U.S. stock market because the high yield bond market often leads the S&P downwards. This is what happened in 2017.


Here’s the fractal to 2007.

Back in my hedge fund days, we actually tried to incorporate this component into our Medium-Long Term Model. It didn’t work. We discovered a few problems with this indicator (we used the BofA Merrill Lynch US High Yield CCC or Below Effective Yield).

  1. High yields have to rise significantly before they can predict a problem for the U.S. stock market.
  2. Not all of the S&P’s significant corrections or bear markets saw high yields rise beforehand. In other words, this indicator fails to predict a lot of significant corrections and bear markets.
  3. There were a few false positives. I.e. sometimes yields would rise a lot and the U.S. stock market still wouldn’t go down. Sometimes yields would rise a lot only for the U.S. stock market to go down 6-10% (i.e. not “significant correction” territory).

Jeff Gundlach cherry-picked the above charts when discussing the high yield bond market. With bond prices flat, high yields have not risen significantly either. So this is not a problem for the S&P 500 right now unless high yields rise a lot. Here’s the yield chart.

High yields are flat right now because this is as low as they get from a long term perspective.

Click here to read The strong U.S. economy supports the bull market in stocks

Failures

Here are examples that demonstrate why the high yield market is not a very consistent, accurate, or timely indicator for the U.S. stock market.

High Yields started to go up in July 2014. The U.S. stock market topped 10 months later in May 2015 before beginning a “significant correction”.

High Yields started to go up in July 2007, 3 months before the stock market’s bull market ended.
High Yields went up January-May 2005. The S&P did not make a significant correction at all.

High Yields bottomed in the beginning of 1998 and went up nonstop. The U.S. stock market made a significant correction July-October 1998. But High Yields kept on rising, even after the significant correction was over and the S&P made new highs.

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