What are bond yield-spreads telling us?… are we at an inflection point in the S&P?… the support level our technical experts are eyeing if stocks sell off

As I write Friday at noon, the markets are selling off.

This isn’t a surprise.

A short-term pullback, followed by a bigger, bullish push higher is the market forecast we’ve highlighted from both Louis Navellier and Luke Lango in recent Digest issues.

In this week’s Strategic Trader update, our technical experts John Jagerson and Wade Hansen featured an indicator that appears to be tracking this market outlook.

It’s showing the potential for immediate weakness. But bigger-picture, it could be turning in favor of a longer-term move for the bulls.

Best of all, this indicator from John and Wade is something you’ll be able to use for the rest of your investing career. It provides a quick, surprisingly accurate angle on stock market direction.

Let’s get into the details.

What the bond market is forecasting for the stock market

For newer readers, John and Wade are the analysts behind Strategic Trader. This premier trading service combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

Fortunately for us, John and Wade are happy to share their arsenal of powerful indicators to provide clues about where the market is headed next. And on Wednesday, they profiled one such indicator that’s coming from the bond market.

Here they are to explain:

One indicator we like to watch is the spread between high-yield corporate bonds – those with a rating below Baa (by Moody’s) or BBB (by S&P and Fitch) – and investment-grade bonds – those with a rating above Baa or BBB.

High-yield corporate bonds typically have a higher yield (hence the name) than investment-grade corporate bonds because the companies that issue them are deemed to be at a higher risk of defaulting on the bonds.

Bond traders demand a higher yield on these bonds to compensate them for the increased risk they are taking.

When the economy is strong, the spread between the yield on high-yield corporate bonds and investment-grade corporate bonds is typically smaller because the risk of any company defaulting on its bonds during good economic times is lower.

However, when the economy is weak – or expected to get weaker – the spread between the yield on high-yield corporate bonds and investment-grade corporate bonds gets wider because the risk of default increases when times are tough.

According to John and Wade, the easiest way to assess this relationship is by looking at a spread chart that compares the ICE BofA U.S. High Yield Index Effective Yield and the ICE BofA AAA U.S. Corporate Index Effective Yield.

Now, how does analyzing bond yields help stock investors?

The relative peaks and valleys on this bond-spread chart tend to coincide quite nicely with the movements of the S&P 500

When the corporate-bond yield spread reaches a low point and starts to widen (meaning economic conditions have been good, but are starting to deteriorate) the S&P 500 tends to hit a peak and starts to sell off.

The opposite dynamic is often true as well.

When the corporate-bond yield spread reaches a high point and starts to narrow (meaning economic conditions have been poor, but are starting to improve) the S&P 500 tends to hit a low and begins to climb.

John and Wade provide two charts (below) to illustrate this relationship.

The first chart is our bond-spread chart. The second is the S&P 500. The data go all the way back to the late 1990s.

As you compare the two charts, notice the numerical reference points and how highs on the bond-spread chart tend to coincide with lows on the S&P chart, and vice versa.

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Now, what’s been happening with these charts recently?  And more importantly, what clues are they providing about the S&P looking forward?

Near-term bearishness, longer-term bullishness

Let’s begin by looking at our bond-spread chart.

Below, John and Wade have added reference points to the localized peaks and valleys here in 2022.

As you’ll see, the overall trend has been up (despite the most recent move, which is down, evidenced by Point 6).

As a reminder, a bond-spread trend that’s been “up” signifies worsening economic conditions, which tends to correlate with pain in the S&P 500.

Obviously, “pain” has accurately described the broad stock market for the first half of 2022.

Below is a chart of the S&P 500 on the year with added reference points.

As you’d expect from the bond-spread chart, the overall trend has been down this year. But over the last two months, stocks have bucked the trend and moved higher.

So, what are we to make of this?

Back to John and Wade:

The question we have now is whether the corporate-bond yield spread hit a high at #5 and is now beginning a new downtrend.

If the corporate-bond yield spread bounces a little bit at #6 but ends up forming a new high that is lower than #5, it tells us the S&P 500 has a better chance of breaking above 4,300 in the coming months.

Let’s flesh this out.

“If the corporate-bond yield spread bounces a little bit at #6…”

This is our near-term potential market direction.

A bounce in the bond-spread chart translates into a drop in the S&P 500.

And in fact, since hitting a recent high on Tuesday, stocks have been trading lower, with losses accelerating today.

Plus, if we look at the S&P’s RSI indicator, it’s been in “overbought” territory and is now losing steam.

For newer Digest readers, “RSI” stands for “Relative Strength Index.” This is a momentum indicator that measures the extent to which an asset is overbought or oversold.

When an RSI reading climbs above 70, it typically points toward overbought conditions. When it dips below 30, that usually corresponds with oversold conditions.

When markets become too overbought or too oversold, they tend to reverse in the opposite direction.

As you can see below, the S&P’s bullish surge that began in mid-June brought the S&P’s RSI into overbought conditions, which has now reversed and is headed lower.

The short-term market trend clearly appears “down.”

But let’s look longer-term…

The question we have now is whether the corporate-bond yield spread hit a high at #5 and is now beginning a new downtrend.

As you know at this point, if the bond-spread chart reaches a peak and begins falling, that typically parallels the S&P hitting a low and rising.

If we look again at John and Wade’s bond-spread chart, you’ll see that it’s already broken its 2022 upward trendline.

As our technical experts point out, if the bond-spread chart bounces at Point 6 but then reverses below Point 5, that will add support to the idea that 2022’s longer-term trend is reversing.

Translation – bond-yield spreads are tightening… economic conditions are improving… and the S&P is rising.

Bottom line: Near-term weakness appears in the cards – and based on the last few days of market action, it’s likely already started – but if the bond-spread chart truly is reversing its trend, stocks are looking bullish in the longer-term according to John and Wade.

As to the extent of any immediate weakness, here’s John and Wade’s short-term support level to take us out:

…We have seen tech stocks start to lose some of their recent gains.

So far, we don’t think there are any serious threats to the market, but a return to support near 4,160 on the S&P 500 is starting to look more likely.

Have a good evening,

Jeff Remsburg