This rally is on thin ice.
After the election, U.S. stocks took off. The S&P 500, Dow Jones Industrial Average, and Nasdaq all hit record highs days after Donald Trump pulled off the unthinkable.
But, as you’ve probably noticed, the rally in U.S stocks has petered out.
The S&P 500 is trading exactly where it was a month ago. The Dow has fallen six days in a row.
These aren’t signs of a healthy rally, and that has a lot of investors nervous. But stocks aren’t the only high-flying asset that could be in trouble. Junk bonds look weak, too.
• Junk bonds are bonds issued by companies with poor credit…
They're more dangerous than government bonds or bonds issued by companies in good financial shape. Because they’re riskier, junk bonds pay higher interest rates than “safe” bonds.
Lately, junk bonds have been very popular with investors.
The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the largest U.S. junk bond fund, has gained 4% since last June.
The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which holds bonds issued by companies with good credit, is down 2% over the same period. The iShares 20+ Year Treasury Bond ETF (TLT), which holds long-term Treasurys, is down 7%.
You might find it strange that junk bonds rallied while “safe” bonds fell. But you have to understand a few things about junk bonds.
• For one, oil companies make up a big chunk of the junk bond market…
A year ago, the oil market was a complete train wreck.
The price of oil was down more than 70% from its highs. It was at its lowest level in more than a decade.
Low oil prices crushed the oil industry. Many companies were bleeding cash. Some couldn’t pay their bills. At one point, analysts warned that half of all oil and gas junk bonds would go bust.
Then, the price of oil bottomed in mid-February. It’s nearly doubled in value since then.
• Higher oil prices saved countless oil companies…
They gave junk bonds a big boost.
In fact, HYG bottomed on the same day that oil bottomed, February 11. It’s since spiked 15%, thanks to higher prices.
But, like stocks, the rally in junk bonds started to fizzle out. You can see in the chart below that HYG hasn’t set a new high since October.
Right now, junk bonds are hanging in there because most investors aren’t as worried about junk bond defaults as they were last year.
But that’s not the only thing holding the junk bond market together.
• Inflation doesn’t hurt junk bonds as much as safe bonds…
Inflation, as you probably know, measures how quickly prices rise.
High inflation is bad for everyday people. It makes the money in their wallet less valuable.
It also hurts people who own bonds, especially bonds with low interest rates…
Let’s pretend that you own two bonds. One is a government bond that yields 2%. The other is a junk bond that yields 5%.
Let’s also assume there’s no inflation (0%) for the first year that you own these bonds. In this case, your “real” return (a bond’s yield minus the rate of inflation) on the government bond would be 2%. Your junk bond would have a real return of 5%.
Now, let’s say inflation jumps to 2% in year two. This would drop the government bond’s real return to 0%. You wouldn’t make any money on it. But you’d still make a 3% “real” return on your junk bond.
In short, inflation destroys the return on safe (low-yield) bonds quicker than junk (high-yield) bonds.
That’s important because most investors expect inflation to rise in the coming months…which is a big reason why Treasurys and other safe bonds have tanked.
• At this point, you might be thinking that junk bonds are a safe place to park your money…
But you have to understand that junk bonds behave more like stocks than bonds. That's because they’re risky like stocks.
You can see in the chart below that HYG has basically moved in lockstep with the S&P 500 since the start of 2016.
• If stocks fall, junk bonds should, too…
And we have plenty of reasons to be worried about stocks.
For one, profits for companies in the S&P 500 stopped growing in 2014. Until profits pick up, we’re going to take a cautious view on stocks.
U.S. stocks are also incredibly expensive. Right now, the S&P 500 trades for 26 times earnings. That means U.S. stocks are 63% more expensive than their historic average.
• The “Trump Effect” is about the only thing keeping stocks afloat right now…
Unlike Obama, Donald Trump brings a wealth of business experience to the White House.
Many folks think Trump’s pro-business policies could jumpstart the U.S. economy. But these same people seem to have forgotten that Trump’s inheriting a huge mess.
Plus, he’s a total wild card. We have no idea what we’re getting with Trump. Frankly, we wouldn’t be surprised if he broke many of the promises that got him elected.
That’s why we’re taking a “wait and see” approach with stocks.
• We also encourage you to sit out the rally in junk bonds…
They’re too risky AND they’re expensive, as you’ll see in today’s Chart of the Day.
We also don’t think you should short junk bonds right now. While it’s lost some momentum, HYG is still in an uptrend. And you should never bet against something that’s got the wind at its back.
• If you’re hungry for yield, we encourage you to invest in world-class dividend payers…
Unfortunately, most U.S. stocks don’t yield much these days.
The S&P 500 yields just 2.0%. That’s less than half of its historical average.
The good news is that we can help you find great dividend-paying stocks…
Nick Giambruno, editor of Crisis Investing, has developed a proprietary system for finding companies with fat dividends. This same system also helps Nick find world-class companies trading at deep bargains.
He calls this system his “Value Radar.” Over the past year, Nick has used this system to generate returns of 103%, 51%, and 40% for his readers.
Most investors never make returns this good. That’s because most people don’t have a system.
They wing it instead. They buy whatever stock is hot or whatever bond pays the most.
• You can’t afford to take those kinds of risks right now…
To see why, watch this brand-new presentation.
It talks about a financial crisis that’s been quietly brewing for years. According to Casey Research founder Doug Casey, this crisis could cause stocks, bonds, and currencies to plunge. It could also put thousands of companies out of business and millions of people out of work.
Most investors aren’t ready for this. They’re still laying out on the beach while a Category 5 hurricane is about to make landfall.
Chart of the Day
Junk bonds aren’t cheap.
Today’s chart comes from The Wall Street Journal. It shows the yield spread between junk bonds and U.S. Treasurys over the past 20 years.
When the spread is high, it means junk bonds are paying much more than Treasurys. When it’s low, it means junk bonds aren’t paying that much more than Treasurys.
Right now, the spread is half of its historical average. In other words, junk bond investors aren’t being compensated for the extra risk they’ve assumed.
There’s not much margin of safety in junk bonds today, either. The Wall Street Journal reported last week:
Junk bonds have defaulted historically at an average rate of 4.2% a year, according to data from Standard & Poor’s. That is more than the current spread, meaning the extra yield investors hope to capture by owning junk could easily evaporate. Investors tend to forget this, especially during periods of low defaults.
In short, this means junk bonds are expensive. Keep this in mind if you’ve been thinking about buying them for their “fat” yields.
Delray Beach, Florida
January 19, 2017
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