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The Stock Market Party May Be Ending. Here’s the Tell-Tale Sign.

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credit spreads - The Stock Market Party May Be Ending. Here’s the Tell-Tale Sign.

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This rally is different.

I keep stressing that the assumption that we rally into the end of the year may very well be misguided. What makes this move interesting in stocks is that, this time around, junk debt is actually beginning to weaken relative to higher quality Treasuries.

Watch Credit Spreads

If we look at the price ratio of the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) relative to the iShares 3-7 Year Treasury Bond ETF (NASDAQ:IEI), we can clearly see there’s a downtrend just getting started. This despite what looks like a strong comeback in stocks over the last several trading days.

A chart of the SPDR Barclays High-Yield Bond ETF/iShares 3-7 Year Treasury Bond ETF.
Source: Source: Chart courtesy of StockCharts.com

We haven’t seen this in some time. Maybe it’s something, or maybe it’s nothing. But the point is that we are starting to see some early signs of credit stress being expressed in the relative movement of high-yield against Treasuries. That’s worth paying close attention to. It suggests the long-awaited corporate credit spread widening (what I call Phase 2 of the credit event) may actually be underway just as everyone is getting bulled up by the recent move higher in equities.

Now, to be fair, maybe this comes right back, meaning spreads narrow again. Not impossible. But if my thesis is right, the crack in the dam becomes the flood. It, I believe, has to happen quickly. Traditional credit scares tend to happen very aggressively and don’t allow traders much time to position correctly for it until it’s largely too late. Under that scenario, even though it doesn’t look like much of a move yet, it can become a big deal soon. This is why I maintain the idea that caution is warranted in the near term.

It’s also worth noting that small-caps relative to large-caps are at new relative ratio lows. I also find this to be a major disconnect. Small-caps are the junk of the equity landscape, you can argue. To see this breadth and weakness continue to be so poor, at some point, has major implications on junk debt. I fail to see how credit spreads stay so tight when beneath the surface, small-caps continue to worsen, suggesting that things remain poor from a conditions perspective.

A chart showing the iShares Russell 2000 ETF/SPDR S&P 500 ETF.
Source: Source: Chart courtesy of StockCharts.com

The Bottom Line

So here we are. The narrative is that we are entering the “best six month window” for equities and the end-of-year chase, while small-caps continue to worsen, credit spreads are only now starting to widen, and social media is screaming about a resumption of the bull market. This, combined with stabilization and potential strength kicking back into Treasuries and utilities, all seems like a perfect storm.

I don’t know for sure that a tail event in stocks will happen in the near-term. However, I am confident that these are the kinds of dynamics that you see prior to one.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.


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