It has been a noisy past week in global markets as the media has done its very best to pump fear into the masses. The topic du jour of course being the Coronavirus, a respiratory illness caused by a novel virus first identified in Wuhan, China. I won’t spend any time prognosticating on the overall economic effects due to this illness as that would be guesswork. What we do know is that these outbreaks (Ebola, SARS, Swine Flu etc.) have been great buying opportunities for the long term. Take a look at the chart below courtesy of Charles Schwab and then let’s leave this topic behind in terms of impact on the markets.
I would argue simply that the market had run too far too fast and was looking for an excuse to pullback. So far, a 3% pullback from all time highs, in a market that went straight up nearly uninterrupted since October seems perfectly normal. So far, stock to market correlation remains low making for a nice environment for those tactically trading individual names and I don’t expect that to change unless we get multiple down days and weeks in a row.
For now I want to turn our attention to a ratio chart. I watch about 30 of these intermarket charts, especially in times of “high noise” or fear in the markets. They help to give us perspective and tend to be leading indicators of strength or weakness in different asset classes. Over the coming days I will try to relay a handful of these intermarket relationships so you can get a feel for how to use them.
Today we will start with the ratio of High Yield Corporate Bonds and Investment Grade Corporate Bonds. Using ETFs this is the (HYG/LQD) ratio.
High yield debt is generally seen rising in markets with a strong appetite for risk. Investment grade debt is the safer more conservative of the two. It is the pair together that is of interest to me. Here is why:
Let’s start from left to right on the chart above. It is easy to see that this ratio took a dive in 2008 and bottomed around the time of the great financial crisis. That bottoming coincided with a stock market bottom that was never taken out, and has gone upward ever since. Fast forward approximately eight years to 2016. This relationship made another bottom multiple times from Jan-June 2016. You might be wondering what happened to stocks in 2016 as this relationship again found a bottom. Here is a chart of the SPX to show you. I highlighted in green 2016:
And finally here we are in present day. The HYG/LQD relationship is back to its familiar old level. One that it is no stranger to when equities are fixing to make new runs higher. Can this one relationship in the fixed income market prove once again to be a near term bottom for stocks?
What do you think?
Trent J. Smalley, CMT