The stock market buy signals in late August and late September were quite strong. Despite that strength we expected a typical bottoming pattern to allow a serious secondary bottom in October (see here). As it turned out that final low arrived a couple days early on September 29th. The recommended investment posture for long-term investors remains unchanged at 90% in equities.
The major US stock indices have rallied sharply throughout October and recouped over 80% of the large correction in August. With the plethora of buy signals from August and September and the degree of technical price recovery, it would be unusual at this juncture to see prices threaten new correction lows in the weeks ahead. One obstacle casting debris on the road for stocks in recent days is junk bonds. Readers have seen us compare the charts of stock indices with junk bonds before when we the sell divergences over the summer. It may be early, but it appears that a short-term yellow caution flag is waving this week as junk bond prices failed to reach new highs while stock prices surged. Any new drop in oil will exacerbate this negative concern.
What Next?
Junk bonds have only been on our radar since the 2014 oil collapse began at a time when oil prices and fracking became the only risk factors influencing high yielding junk bonds. Oil shale fracking investments and debt service have become risky as oil prices have fallen. With oil in a to a barrel trading range for the past 2 months we suspect the next move outside of this range will be pivotal for stock prices. Any Oil uptrend is positive for stocks short-term and an uptrend above implies a sigh of relief wave that would propel stocks to new record highs. A sustained move under favors a sharp pullback in the stock market. Currently oil prices are at the bottom of this range near a barrel. Any move down in oil from here will send junk bond prices lower and begin to weigh on stock prices.
Bond Spreads Widen
While the 25 year data sample below may reveal only a few examples, we should also be wary of the historic spreads in junk bonds compared to investment grade bond yields. All 4 examples of Junk bond yields surpassing 700 basis points over Investment grade yields were near recessions and/or stock market corrections. Oil price stability will be required to reverse this growing credit risk and for stocks to continue higher.
Stocks Have Weakness for Yen!
Due to the carry trade, Japanese and US stocks benefit from a depreciating Yen currency. As economic weakness becomes apparent and Japanese authorities engage in further efforts to stimulate through quantitative easing (QE), the Yen weakens and stocks rally. Below we show this strong inverse correlation with an inverted Yen and stock prices. Recently stocks rallied as the the Yen fell (a rise basis inverted Yen below). Now that the inverted Yen has reached important 2 month resistance levels as stocks have become short term overbought, we should be cautious here as the Yen tests resistance just over 90 (8235 support basis Dollar/Yen). Higher Oil prices and signs of economic strength in Japan would support recent stock market uptrends, while the reverse is also true.
The many buy signals reached in August and September are showing no signs of overbought reversals as sentiment is still cautious. It may require new record highs in stock indices before most measures we follow move back to the sell side longer term.
Oil, yen and junk bond prices will be your tell for stock indices.
