By Justin Spittler, editor, Casey Daily Dispatch
We haven’t seen the worst yet.
U.S. stocks could soon head much lower.
That’s the last thing investors want to hear. After all, the S&P 500 is down 9% since September 20. The Nasdaq is down 12% over the same period. And the once high-flying FAANG stocks are down 20%.
But I have good reason to be bearish.
The bond market is flashing danger. I’m not just talking about one or two red flags, either. We’re seeing stress across the credit market.
I’ll show you what I mean in a second. But I should first tell you why I’m watching the bond market for clues about what stocks might do next.
• The credit market is seen as the “canary in a coal mine”…
There’s a reason for this.
The bond market is the biggest market on the planet. The U.S. bond market, for example, is almost twice as big as the U.S. stock market.
And because it’s such a deep, liquid market, the bond market is where big institutional money plays. So you must pay attention to the bond market to know where the real money is flowing.
That’s why I wrote this essay.
• Cracks are appearing in the credit market…
Just look at what’s going on with junk bonds.
Junk bonds are bonds issued to companies with poor credit. They are riskier than bonds issued to companies with good credit… So they yield more.
When times are good, many investors load up on junk bonds. This is because they pay well and the risk of default is low.
When market conditions are bad, investors do the opposite. They dump junk bonds because many highly leveraged companies may struggle to pay back their loans.
In short, a sell-off in junk bonds can act as an early warning sign.
With that said, take a good look at this chart. You can see the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has fallen 3% since October 1.
That alone is concerning. But it’s not the only reason I wrote this essay.
High-grade corporate bonds are also getting hit hard. In fact, inflows into high-grade bond funds fell from $1.85 billion to $755 million two weeks ago. That’s a decline of almost 60%.
High-grade corporate bonds are now on track to have their worst year since 2008.
In other words, investors aren’t just pulling out of junk bonds. They’re lightening up on corporate bonds across the board.
But there’s more…
• Credit spreads are surging…
A credit spread measures the difference between the interest rates on two different bonds.
Below, you can see that the options-adjusted spread (OAS) between junk bonds and investment-grade bonds – bonds issued to companies with strong credit – just jumped to its highest level in two years.
This tells us that investors are demanding a steep premium to own junk bonds. And that doesn’t bode well for stocks.
We’ve also seen a massive spike in the spread between junk bonds and Treasuries.
This, too, is a major problem. To understand why, look at the chart below. It shows the same data set going back to 1997 [the blue line], as well as the level of the S&P 500.
You can see that the spread between junk bonds and Treasuries started spiking about three months before the S&P 500 topped out in October 2007.
The S&P 500 went on to fall 57% before bottoming out in March 2009. That’s a devastating decline.
Unfortunately, we’re seeing similar stress in the credit market today. That tells me we could see a lot more downside in U.S. stocks.
• Many investors aren’t taking this seriously…
I say this because just a few weeks ago some commentators were pointing to strength in junk bonds as a reason to be bullish on U.S. stocks. Just look at this recent headline from MarketWatch:
Of course, junk bonds are no longer resilient. They’re crashing.
• So consider “playing defense” if you haven’t yet…
Here are three simple ways to start:
Hold more cash than usual. Holding more cash than usual will prevent you from suffering huge losses when the market turns down.
Own “defensive stocks.” Holding more cash will also provide you with “ammunition” to pick up great stocks at cheap valuations. As I explained in this Dispatch, blue-chip “basics” stocks are great investments during financial crises. These are the types of companies that sell goods people can’t live without… Think cheap food, toilet paper, laundry detergent, and shampoo. (Read more here to see why these all-weather stocks could save you from huge losses during the next major stock market crash… and even make you a lot of money.)
Own physical gold. As we often remind readers, gold is real money. Unlike paper currencies, it’s survived every financial crisis in history. If stocks fall, investors should pile into gold like they’ve done many times before. To learn more about gold and the best ways to add some to your portfolio today, check out our free report: “The Gold Investor’s Guide.”
These simple steps will prevent you from taking huge losses if the stock market crashes.
New Orleans, LA
November 27, 2018
Today, a reader responds to our recent Dispatch: “What to Buy When the Market Loses Its FAANGs”…
Personally, the only surprise to me is that it took so long for the tech sector to start failing. Artificially low interest rates, debt which can never be paid, and fake money, period. This time is not different, and it never will be. The last market crash remedied with the same BS that created it. Cash, gold, and QQQ puts are most of my portfolio now along with cryptos. Just my two cents.
As always, if you have any questions or suggestions for the Dispatch, send them to us at [email protected].
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