Are Cracks Forming in the High-Yield Bond Market?

While high-yields bonds (HYG) have held up better than equities, there are signs of cracks forming.

Negative developments at GE have caused some to speculate more highly leveraged borrowers are looking at downgrades.  The lower tiers of investment grade ratings currently represent a large number of bonds and if we see a series of downgrades pressure could mount on the corporate bond market, both investment grade and high-yield.

I am still viewing this entire episode as a cycle slowdown and not the end of the cycle.  The Fed will likely put the break on interest rate hikes in 2019 if credit markets continue to rumble.  The real estate market has already broadcast a slowdown and change in buyer behavior attributed to higher interest rates.  Weakness in the corporate bond market has their attention.  One aspect that may be overlook in the corporate market, however, is the impact of corporate tax reform on the ability of borrowers to service debt more effectively.

The U.S. economy is still doing well and there may be more to come if congress can get together on an infrastructure project.  Trade talk with China remains a risk but so far the impact to the U.S. has been limited.

I have set another alert for the high-yield market.  Should it trigger I will become more concerned about junk bonds rolling over which would likely represent a negative development for stocks.

Sellers Push Markets Lower; Most Stock Breakouts Hold

After a swift and intense decline in October, U.S. stocks are trying to rally but face renewed selling pressure in November.

One of the current challenges is the performance of international stocks.  The economic recovery and central bank policies of Europe, Japan and China continue to lag results in the U.S.  This divergence has created a significant valuation gap and instead of international stocks catching-up to the U.S., investors may be looking to revalue U.S. stocks lower.

Here is a look at the Price to Earning (P/E) and Price to Book (P/B) ratios of international (EFA) and emerging market (EEM) stocks compared to the S&P 500 (IVV).

IVV  P/E 23.29, P/B 3.33  (U.S. Stocks)

EFA  P/E 13.87, P/B 1.59  (Developed Country Stocks)

EEM  P/E 11.94, P/B 1.52  (Emerging Market Stocks)

State Street, BlackRock, Dightman Capital as of 11/12/18

As the data above shows, U.S. stocks are trading at a premium to the rest of the world.  The P/E ratios above are calculated using 12-month trailing earnings.  If 12-month forward earnings estimates were used the P/E ratio for US stocks would be significantly lower.  Strong earnings growth projection for U.S. stocks explains why there is such a large difference between trialing and forward P/E calculations.

The risk to U.S. markets is a reduction in the P/E and P/B ratios through lower stock prices despite a healthy U.S. economy and corporate earnings environment.  Stocks could trade down another 10-20% from current levels to narrow the gap but U.S. stocks should be able to maintain their independent valuation despite lower growth and valuations in other parts of the world.  This would be based on continued sales and earnings growth.  High growth environments are often reward with premium valuations.  In terms of opportunities in international stocks, eventually they may represent an attractive investment opportunity but as a group they appears to have more economic work to complete before they can stage a strong recovery.

Interestingly, leading growth stocks have held-up pretty well during the selling this past week with the number of stocks reaching new highs for the NASDAQ well above lows back in October.

It will be important for the New Highs-New Lows index to move back into positive territory.  The performance of leading stocks is an important sign of when to potentially take defensive action.  If high-growth stocks are holding up in a market correction, the likelihood of a bear market is lower.

End of This Cycle

Some commentators are suggesting we are at the end of this cycle.  However, they may be failing to recognize that in this cycle we spent the first 8 years in repair mode and only recently began a phase of strong economic growth.

Weak Credit Markets

Another clue to the health of the overall environment can be found in credit markets.  Some commentators have suggested the flat yield curve is a sure sign of a pending recession.  What they may fail to realize is this is a common occurrence for years leading up to a recession as short-term rates move higher while long-term rates remain somewhat anchored due to a deflationary trend cause by globalization.  We are only one-year into a rate rising process and remain at very low rates.  Some rate sensitivity has been reported which may help The Fed pause at some point in 2019.

High-yield bonds are holding up well which is something we would not expect if we were moving towards a change in the market cycle.

Mid-Term Results

The stock market had a strong day on November 7th and some observers believe there is a reasonable chance of an infrastructure bill passing which should be well received by the market.

Trade Negotiations

In terms of the international trade, progress has been accomplished.  However, China and the U.S. have very different approaches, definitions and attitudes on the subject which could mute economic growth next year if an agreement is not reached.

There are always risks and “what if” considerations when monitoring market cycles.  On balance I believe we are still in an expansionary phase economically which could last longer than many people anticipate.  There are risks and conditions could change quickly but in total I believe the current selling is corrective in nature, and even if we see additional declines, I believe stocks will resume the current uptrend.

Brutal Correction

Back on October 15th in market commentary I wrote, “A scenario is developing which could push stocks further into the red in the coming days and weeks…”

On October 20th I wrote, “I do not expect the current situation to resolve itself quickly.”

To be fair, the stock market could have moved higher from each of those dates, but it hasn’t, the selloff has intensified.  There is one primary reason I felt it could get worse before it gets better.  This is a mature market.  I don’t believe the I bull market is over.  I do believe, for it to continue advancing, values need to be reset and that is what is happening.

Those investors with more than a few years of investment experience know that periodically we enter into corrections and occasionally bear markets.  The difference between a correction and a bear market has to do with the degree of the decline.  Bear market also usually last much longer.

The primary culprit of the current sell-off is interest rate related.  The good news is that a statement by the Fed that they are going to review future rate hikes and reconsider their plans could stabilized the market.  This is likely to happen if the situation deteriorates any further.  A credit/consumption-based economy is very sensitive to interest rates.  Like a ballast, interest rates have the potential to tip the stock market if they rise to far too fast.  Several real estate reports have recently indicated a slow-down in activity being attributed to higher interest rates.

Corrections are a necessary part of investing.  They allow the market to reassess value.  Higher interest rates require future cash flows for stocks to be discounted at a higher rate causing them to be worth less. Once the market has revalued stock prices based on higher interest rates the bull market underway should continue.  A pause in rate hikes could make this process smoother.

It is possible we could see the situation deteriorate further.  If it does investors are best served to hold tight.  Often the market overreacts in this type of situation but eventually sprints higher.  You don’t want to be out of the market when that happens.

Of course, investments in money markets, bonds and gold can provide some refuge during difficult stock market conditions.

Triggered Alerts – 10.23.18

Marketsmith, Dightman Capital

Immediately at the open this morning I had two alerts trigger.  One alert was for stock based investment that was under selling pressure.  The volume of shares traded immediately at the open was much larger than normal.  Overall, the price was down around 2%; firmly below the 200dma (black line).  As I suggested in recent commentary related to the current selloff, the additional selling I thought had a good chance of materializing has arrived.

Marketsmith, Dightman Capital

The other alert I received this morning was related to gold.  The ETF GLD gapped up at the open and looks poised to continue climbing.  This is the type of action you look for from gold in a portfolio.  According to ETFReplay.com, the ETF GLD has a correlation to the S&P 500 ETF SPY of +0.08, which is only slightly positive.  Correlations have a tendency to change and right now gold appears to be delivering a negative correlation, which is what you what to see during a stock market selloff.

Evaluating Current Market Support and Breakout Levels

Stock market trading settled down this past week providing an opportunity to evaluate trading levels and set technical alerts for support and breakout points.

Below is a snapshot of a equity investment I follow closely.

As you can see in the chart, it has been seven days since the investment closed below the 200 day moving average (Black Line Below Price Bars).  During the last 5 trading days support has been held at this line.  Notice the investment has closed just above this support the last two days and at the bottom of the range of the trading range (Small Horizontal Line Across The Longer Vertical Blue & Red Lines Represents The Closing Price).  Volume has been heavy (red and blue vertical bars in the section below the price) which suggest sellers were met with an equal level of buying at these prices.

Marketsmith, Dightman Capital

The first support level for this investment is currently near the 200dma (day moving average).  There is also support at the bottom the price range where this investment traded below the 200dma.  It is too early to tell if we will revisit those levels again but so far buyers have been willing to come in and support a price above the 200 day line.  Continued support at the current price level would suggest the worst of the selling is behind us.

Trading this last week has also provided a potential break-out price level.  If the price of this investment moves above the trading level from 3 days ago, that would indicate buyers have regains some control which may indicate the worst selling from this correction is behind us, increasing the likelihood we rally into year end.

I do not expect the current situation to resolve itself quickly.  I believe investors are reluctant to come into this market because so many commentators are suggesting this is the beginning of the end of this bull market.  It believe they are wrong and those investors that take an overly defensive position into 2019 may be leaving money on the table.

We have two big dynamics at play that are supporting this market.  A strong U.S. economy, which we have not had since the Great Recession of 2008, and a technology renaissance touching a wide variety of industries.

Excellent Technical Analysis Example

There are a lot of technical indicators used by stock investors.  Some screens are so filled with colors, lines and data it tough to make heads or tails from what you are looking at.

It is helpful to remember there are only two data inputs.  Price and Volume.  Price determines the trade direction and volume establishes conviction.  Focusing on these two variables and adding a simple relative strength indicator can yield a great deal of information about the potential near-term price action.

Take the example below.  This is a high-growth tech stock that has delivered outstanding returns to investors over the last couple of years.  This stock when public in 2015.

Marketsmith, Dightman Capital

In weekly chart above we can see three different basing patters (identified by the green dots and curved line).  Two of these bases were consolidation types and the middle base was a cup w/handle type (the handle slopped upward which is a potential concern).  The most telling part of the current late stage base (also a warning) can be seen when comparing it to the prior consolidation base of about a year ago.

Notice how the current base is downward sloping (current price is near the bottom of the base range).  The base this stock produced over a year ago featured the price staying more in the middle and then upper range.   You should be able to see an upward sloping trend just looking at it.  The current consolidation is producing the opposite, a downward slope.

Below the price bars you see the blue relative strength (RS) line. The RS line measures the price performance of a stock with the price performance of the S&P 500.   If the line is trending higher it is outperforming the market.  For growth investors often a new high on the RS line is a bullish buy signal.  It is extra bullish if this line hits a new high ahead of the price.

In this example, the RS maintained an upward slope during the first two bases.  Now it is starting to exhibit a downward slope.  The red lines over the RS were drawn to show the change in slope.  Notice how in the first base the slope of the RS line initially weakened.  This is normal and to be expect as a stock rests.  It is possible the stock above will still move higher and the RS line will turn higher.  But, if the price of this stock moves below the bottom of the current base consolidation, that would increase the probability this stock is going to see weaker price performance in the near-term.

Should Investors Prepare For More Market Declines?

The stock market experienced swift and deep downward action last week. Part of the market selloff points to typical action by institutional investors and looks very similar to the February decline. This type of trade action includes Option Gamma Hedging strategies, where traders profit from increased sensitivity to an option’s price change measured by gamma. Much of this type of selling is believed to be behind us.

You also have the Trend Following crowd, once indexes made a strong move below the 50-day moving average selling and short exposure increased, which aggravates moves to the downside.

This week Volatility Sensitive Strategies (investment allocations that shift between cash and the S&P 500) and Risk Parity Strategies are expected to be active. Some trading desks suggest there’s around $355Bn allocated to this category of trading. Stock exposure for these strategies is believed to already be down to around 65% from 100%. Another 15% reduction is still expected.

Goldman Sachs reported good flows into their Corporate Buyback desk but as you can see in the chart below (Stockcharts.com & Dightman Capital), it was not enough to establish firm support. Trading volume on Friday was significantly below recovery rallies earlier in the year and selling volume for S&P 500 stocks was significantly higher.

The Tech Premium, the higher cost an investor is willing to pay for tech exposure versus other areas of the stock market has faded a bit and may have further to fall. One area contributing to the compression in tech stocks involves international growth. There is concern international market are going to fall into recession before they kick into a higher growth mode. Rising Costs are also weighing on tech. While top-line growth is steady, margins are being compressed as costs, like wages, are rising.

On the geopolitical front, Trade Talks with China should be quiet (but probably won’t be) leading up to the November G-20 meeting but Saudi trouble and the Price Of Oil is a new issue for the market to digest. Brexit talks are not progressing well with many obstacles remaining so that may be causing traders in Europe to sit on the sidelines.

Q3 Earnings ramp up this week, so we will know more about the health of corporate finance throughout the week. Disappointing results or poor guidance could send stocks lower.

A scenario is developing which could push stocks further into the red in the coming days and weeks, or at least mute any recovery.  More downside for the stock market would provide cover for The Fed to become more dovish and slow interest rate hikes. This would likely be a welcome development for stock investors but in the meantime, we may see a bit more pressure on stock prices. From a longer-term perspective this looks like it may end-up being a buying opportunity on the strength of the U.S. economy, a renaissance in innovation and low interest rates globally.

 

Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

Are Tech Stocks Going On Sale?

The U.S. stock market has come under pressure despite good Q2 earnings and the continuation of strong economic numbers.  The price declines are especially prevalent in tech industries while other sectors of the stock market have held up over the last week.  What is the market telling us?

In simple terms, technology stocks may be going on sale.

It is clear Facebook and Twitter face unique and systemic business challenges, but the massive declines they have experienced in the last few days seem to be taking down other tech related stocks.  The software industry, for example, is down nearly 5% from highs reached just 5 days ago.  More specifically, Cyber Security is down nearly 6% from highs it reached on July 18th.  Biotech is another example, down 6% since July 12th.

Company valuations are also a concern.  Technology stocks have become expensive and those companies with strong growth fundamentals, primarily sales and earnings growth, generally trade at a premium to the market, during rising markets.  There’s little evidence business conditions for tech companies are contracting so the decline in price appears to be a typical correction bringing tech valuations closer to the broad market.

Other sectors of the stock market do not appear to be impacted by the tech selling, at least so far.  How can we tell?  For one thing, other stock market sectors have been able to avoid the selling:  Materials (XLB), Industrial (XLI), Consumer Staples (XLP), Energy (XLE), Healthcare (XLV) Utilities (XLU), Financial (XLF) have all generated positive returns over the last 5 trading days.  7 out of 11 sectors delivering positive returns.  These are not just defensive sectors either.  The Financial Sector participation is a bonus, suggesting these financial companies have not been impacted significantly by problems in the tech space and valuations in this sector are actually quite reasonable.

Other groups have also been able to side-step the selling over the last 5 days.  Transportation, Healthcare, and Consumer Staples, just to name a few.

Below is a look at the price performance over the last two months of the 11 SPDR Sectors, considered a good proxy for the entire U.S. stock market.  Recent selling appears to be focused on technology related companies;  However, talk of a government shutdown has the potential to aggravate the situation; it would be wise to proceed cautiously with any new investment.

(NOTE: The recently introduced eleventh “Communications Services Sector” (XLC), has an 18.5% allocation to Facebook, and 26% to Google.  The largest traditional “Telecommunications” holding is Verizon, which only represents 4.8% of the sector ETF.  A good example of why it is important to know the actual holdings of any mutual or exchange traded fund.)

As of July 30, 2018. StockCharts.com