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 The most recent decline in the S&P 500 marks the third time in six
months that the market has looked wobbly and threatened a
significant reversal. Each time, so far, it has bounced back
quickly.
But what has some investors most worried this time around is the
recent, notable underperformance in junk bonds in the past few
months. In the past this has been a precursor to bearishness in the
equity market.
High-yield corporate bond spreads <.MERH0A0>, the premium investors
get for purchasing low quality corporate debt as opposed to
benchmark U.S. Treasuries <US10YT=RR>, have been increasing steadily
since late June. A widening spread means their performance is
lagging higher-quality bonds.
The spread has since widened by more than 100 basis points,
according to Bank of America-Merrill Lynch data. Previous spikes of
this magnitude have preceded pullbacks in the S&P 500, and the
greater the selloff in high-yield debt, the worse the outcome was
for stocks.
"Spreads are widening and it's certainly not a good time for
equities. It doesn't have to be a terrible time, but it's telling
you people are on the margin taking risk off," said Paul Zemsky,
chief investment officer of Multi-Asset Strategies and Solutions at
Voya Investment Management in New York.
He said that while reduced liquidity in the high-yield bond market
could exaggerate the moves in spreads, the overall signal is of a
marked shift in sentiment.
"I do think (the spread) has some information in terms of risk
appetite and how people see economic growth," Zemsky said.
High yield most recently started widening against Treasuries
beginning on June 23, when the S&P 500 was around 1,960, with the
peak set earlier this week at an increase of 116 basis points. The
S&P closed the week at 1,967.90 while the yield spread tightened
slightly to 107 basis points.
The last time such a shift in spreads started was in May 2013, and
it preceded a near 6 percent fall in the S&P. Weakening in junk
bonds in early 2012 also preceded an S&P downdraft between April and
June 2012, when the S&P last flirted with a 10 percent drop.
However, the move may not yet signal a market correction. As has
been the pattern in 2014, investors are content to move money
between different stock market sectors rather than flee altogether.
Small-cap shares entered a correction at one point this week and the
S&P energy sector fell 13 percent from their 2014 peak, but
investors piled into the healthcare sector <.SPXHC>, which hit a
lifetime record early last week.
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In April 2011, high yield spreads began widening in a move that
eventually reached 450 basis points. Stocks didn't begin to correct
until the spread had moved nearly 100 basis points, but eventually
they sank nearly 20 percent.
"If you run a chart of junk spreads going back five years this move
is tiny. We’ve seen much, much bigger moves in junk, and much bigger
selloffs in junk in the last five years," said Brian Reynolds, chief
market strategist at Rosenblatt Securities in New York.
The current spike, he said, "did predict (the move) in stocks, it
did follow through and we’re probably now reaching a climax of
panic," he said.
This is why the next move in credit spreads becomes key. Next week
is relatively light for economic data. Investors haven't run
entirely from bond markets, but have shifted funds around. High
yield funds saw an outflow of $2.3 billion in the most recent week
to Oct. 1, the most since early August, according to Lipper, as they
moved money into high-grade corporate debt.
The focus may shift again to escalating conflicts in the Middle
East, the stubborn weakness of the European economy, or the outcome
of Hong Kong pro-democracy protests that are challenging the
authority of Beijing.
For Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds
Management in Menomonee Falls, Wisconsin, the key lies in earnings
reports, which begin in two weeks.
"If we don’t get earnings corroborating the (bearish) story being
told by spreads, then I think we’ll see the spreads come in."
(Reporting by Rodrigo Campos; Editing by Martin Howell)
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