When it comes to trading the stock market, you need any edge you can get.
Yet many traders overlook one corner of the markets that can reveal important clues about the next move in stocks.
That’s the high-yield bond market, also referred to as junk bonds.
Companies with poor credit ratings issue these bonds. The companies have lower financial quality. Typically, they carry high debt levels on their balance sheet or low profits relative to their interest payments.
In other words, high-yield companies are at higher risk of defaulting.
But that also makes their bond prices extremely sensitive to the outlook for the economy.
In fact, sometimes junk bonds move before stocks. That can tip us off about changes in the stock market’s direction.
So today, let’s unpack what junk bonds are saying about the market… and if a major change is around the corner…
Bonds Tipped the Bull Market
In mid-October 2022, the S&P 500 was stuck in a bear market. It had declined 25% from the peak.
But junk bonds signaled that the bear market was about to end.
On October 12, the S&P was making a new low. But the iShares iBoxx High Yield Corporate Bond ETF (HYG) made a higher low, as you can see at the arrow in the chart below.
Not only that, but the relative strength index (RSI) was quickly improving as well (circled area). That showed strong momentum behind HYG’s upside move.
This proved to be the bear market low for the S&P 500. And HYG’s price action has confirmed the uptrend in the S&P ever since. It has kept making higher highs and higher lows along the way.
But over the past month, junk bonds flashed a major warning signal that a reversal was coming…
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Major Negative Divergence
Since peaking on March 28, the S&P 500 has seen a quick 5% pullback.
And junk bonds were warning that this pullback was a growing possibility.
That’s because of a massive negative divergence that you can see with the RSI in the chart below.
Just as HYG was finally moving to new all-time highs, momentum was stalling at a key level.
You can see the difference between price and RSI in the dashed trend lines.
Following that divergence, HYG peaked a day ahead of the S&P 500 on March 27. It has moved lower since.
But look at what the pullback is doing to the RSI…
The RSI is near extremely oversold levels (shown with the circle). It has been this oversold just eight times in the past three years.
So for the bulls to stay in charge, we want to see something similar to October.
At that time, the RSI was at an extremely oversold level and had a quick recovery back over 50. That led to new highs.
If this repeats, that would be a great sign for stocks as well.
But if RSI can’t break above 50 and HYG loses price support at $75.50, then junk bonds are telling you this pullback in stocks isn’t over yet.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict