foxex: Junk Bonds Keep Dropping as Oil Spikes

Chart Advisor | Focus on the Price

Monday, April 22, 2019

1. Oil spikes to resistance on Iran news

2. Large caps continue to outpace riskier classes

3. Watch "junk" bonds for signs of weakness

Major Moves

Stocks were mixed today as investors prepared for the busiest week of first-quarter earnings season. By the end of the week, more than 45% of the S&P 500 will have reported their earnings and we will have a good idea for the trend of corporate performance.

Risks were somewhat compounded today following news that President Trump will make another move to curtail oil exports from Iran. Currently, some oil importers like China, South Korea, and Turkey have a "waiver" from the US that they will not face negative consequences for doing business with Iran.

President Trump plans to not renew these waivers that expire on May 2nd. The administration has assumed that Iran's market-share can be consolidated by Saudi Arabia and other OPEC nations who will increase production. Clearly, the US cannot dictate production levels to OPEC, but it is reasonable to assume that if Iranian exports are reduced, Saudi Arabia will want to increase its own production to offset its worrisome fiscal deficits.

Despite assurances that supply slack will be taken up by other producing nations, oil prices spiked higher today. In the following chart I have used the price of West Texas Intermediate (WTI) oil prices to illustrate the surprise reaction.

Interruptions in the supply of oil are hard to forecast accurately, so it is common for the market to overprice an event like this. In my opinion, I think the rally is unlikely to continue further. Production levels from the US, OPEC, and other producers will likely bring the market back into equilibrium soon.

I consider it a high probability that prices will treat the current pivot near $65.80 as a resistance range. If I am correct, today's unexpected gains may wind up compounding losses in the short-term as investors take profits from their long positions in oil and oil-based stocks.

S&P 500

Earnings have been 'less bad' than expected. Estimates had declined over the last several weeks to an expected contraction of -2% or more across the S&P 500. However, so far, earnings are flat compared to the same quarter last year and revenues are down less than expected.

This has largely been because of the surprises from the big banks. I don't expect to see earnings remain positive, but the bank surprises are still likely to keep the average above expectations. Despite better than expected performance, the reports have thus far been insufficient to move the S&P 500 outside its rising wedge consolidation pattern. At this point, I don't expect the large cap indexes to break to new highs until small cap and high yield bond performance improves.

Procter & Gamble Reports Earnings as 'Inflating Parabolic Bubble'

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Risk Indicators - High yield bonds

For several weeks most risk indicators have either indicated a positive outlook or neutral. Besides a yield curve inversion, investors have shown few signs of stress. This week will likely be a critical one for a key indicator that could flip to a more negative outlook: high yield (AKA "Junk") bonds.

I have mentioned in prior issues of the Chart Advisor that junk bonds act a lot like stocks, but these instruments will often signal a downturn earlier than it can be detected in the stock indexes. For example, junk bonds had already broken support about a week before stock prices collapsed on October 10th, 2018.

Although large cap stock prices have been relatively stable over the last week, junk bond indexes are weakening noticeably. If you pull up a chart of the iShares High Yield Bond ETF (HYG) you may not really appreciate how extended junk bonds really are right now. Most charting platforms incorrectly account for dividend payments which makes the chart of junk bond funds look like they are merely near prior highs.

However, the following chart correctly adjusts for dividends to make apparent how extended this asset class has become. My primary concern is that high yield bonds have completed a bearish MACD divergence over the last two sessions. Bearish oscillator divergences don't have the best track record in a bull market, but, in my view, this one deserves attention considering the scale of the prior rally off December's lows.

If junk bonds continue to decline, investors should plan for a much higher likelihood for large cap stock indexes to follow. I wouldn't expect such a signal to trigger a bear market, however, a correction (-5-7%) wouldn't be unusual.

Read more:

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Everything You Need to Know About Junk Bonds

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Bottom Line - Look for value if the market dips

From a technical perspective, the market is still in an uptrend and deserves the benefit of the doubt. Fundamentals have weakened since the second quarter of 2018, but hiring and economic growth is still positive. While I would urge a cautious outlook this week, I think investors should use any declines as an opportunity to look for value on the dips.

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