Generally the bond market is considered “smarter” than the equity market.
One of the reasons is the mere size of the bond market. Estimates for the U.S. bond market put it around $40 Trillion with the global bond market over $90 Trillion. The equity markets are around half that size.
Another reason the bond market is considered smarter, rightly or wrongly, is the retail investor is typically not directly involved in bonds. They utilize mutual funds and advisors mainly to gain bond exposure as purchase decisions are often influenced by these intermediaries as much if not more than the retail investor themselves. Contrast this to the equity market where the retailer has direct and easy access, making trades whenever they want with a click of the button.
Regardless of the differences, there are also some similarities, especially when it comes to certain kinds of debt.
High Yield Bonds
The high yield bond market (NYSEARCA:JNK) is the closest behaving market to equities.
One of those reasons is because the higher yielding debt is typically the last piece of debt that gets paid from earnings. The collateralized and safer debt tranches usually take priority. Furthermore, bond interest payments are always paid before dividends, one of the reasons bonds are attractive as an investment and also why they typically are less volatile and more reliable an investment than equities. Bond interest is always paid before equity dividends.
Because high yield bonds (also known as junk) are similar from a legal perspective, residing just above equity in the payment pecking order, junk bonds behave very similarly to their respective equities from a price movement perspective.
This is why many investors like to follow the junk bond market (NYSEARCA:HYG) for signals that may eventually affect equities.
Junk bonds can often be the proverbial canary in the coal mine. If there is going to be any disturbances going on behind the scenes, it is likely the bond market will sniff it out before the equity markets do. After all, if the smarter, safer, and less volatile high yield bond market is misbehaving, it is likely the more volatile and less “smart” equities will soon follow.
Also see: How we called the Euro’s top months ago
Junk versus Equity
Check out the chart below showing JNK along with the S&P 500 which is similar to one I provided our subscribers earlier this week. Generally the two markets are very correlated, as shown in the bottom section of the graph, meaning they move in similar directions most of the time. This is a testament to their similar characteristics, but recently something has happened as the dip in correlation alludes to.
Notice that JNK (the colored line) has not made new highs and is close to making new lows below its July levels?
This is synonymous to the S&P (NYSEARCA:SPY) falling below 1900, around 4% lower.
More specifically, JNK has double topped with its June and August highs as price continued to fall on Thursday and is now breaking below its 200 day MA at $40.25. Even though the equity markets saw huge rebounds Wednesday, Sept 24, the high yield bond market did not confirm that bounce, finishing down on the same day and warning that the bounce in equities likely would not stick. That came to fruition the following day as Thursday, Sept 25, saw the downtrend resume with major selloffs in all markets.
A similar early breakdown in high yield bonds (NYSE:HYT) occurred in May 2013 that also helped warn of that continued decline in equities into June 2013, a testament to its leadership.
If JNK falls below its July low at $40, I think it offers an opportunity to short as the weakness in high yield debt (NYSEARCA:SJB) would warn all is not well for equities. This demands attention over the coming weeks.
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