Is High Yield Signaling An All Clear?

In case you haven't noticed, the high yield bond market has been rejuvenated lately to unbear-like behavior.The HYG high yield corporate bond ETF is actually up more than the Dow YDT, putting it ahead of about everything except utilities and gold. The inflows into these bonds have been looking up recently as an article  "High Yield Market Technicals" just out by AdvisorShares points out.

Why Care About High Yield Bonds If You're A Stock Investor ?

Why is this important? I watch this because one of my principle maxims is that the credit market leads the equity market.It usually is the early warning for any major change in market complexion.I watch bonds mainly for early warning on downturns, because the warning is typically very early and pronounced. But high yield also tends to turn up ahead of stocks at the end of declines too.If you look at HYG vs SPX in the September, 2008 to March, 2009 time frame, you see HYG not making a new low on March 9 and getting back to pre-crisis levels much sooner than stocks.

So is this more risk sensitive area of debt showing a turn for the better? Well, for all of 2015, this area experienced a $7.1 billion net outflow of funds whereas just the first three months of this year saw a $6.1 billion inflow! That is a strong turn, especially considering that commodity prices, the predominate affliction with high yield, remain very weak and are not making any such big turn.  But to see if the debt market is really signaling any big turn up, we have to step back a few paces and look at this 15 month change in fund flows in context: 

(Click on image to enlarge)

Here we see the market leading nature of the Russell leading the Dow downturn and the debt market leading the Russell. Debt made the bear turn a year before the small caps of the Russell, and the leading small caps have not rallied to anywhere near new all-time highs as the Dow has done. I wrote a whole article on these megaphone formations as they have been a feature of every major US bear market since 1850. The graph above suggests that the good year high yield flows are having so far compared to 2015 is just a bear rally in the bigger picture. However, HYG is at a critical juncture now, and if it were to do a convincing break-out from the down-trending progression shown above, it would likely be our first good clue of a positive stock market ahead.

It's All About Oil

Much analytical effort is being focused on the energy companies, the high yield boogeyman, and when and if they will recover from the oil price slump, and ease the high yield problems and thus the stock market. The price of oil is a mystery wrapped in a puzzle and locked in safe with the combination encrypted by Apple with no back door. You can tabulate rig counts, inventory build, break even price for the drillers all you want, but nobody really knows what the oil price is going to do. And it is so important because it pulls around the massive debt market, which in turn pulls around the whole stock market. So we'd really like to know what it's going to do.

Even if you don't own a single energy name, stock investors should care about oil these days because of the energy company debt dominos all linked together with a record amount of derivatives, with these all wrapped around the big banks, which wrap themselves around everything. It is credit defaults in high yield that is the problem, and these may be a big problem even if oil climbs back to $60 a barrel. 

EOG has said that it will not unpack mothballed production until the oil price is over $60, and they are one of the more cost efficient major producers.A recent article "Shale Producers Can't Make Money At An Oil Price of $60" did an in-depth tabulation of all this, which is corroborated by a Forbes piece"Big Oil Gears Up For $60 Break-even Price As Profits Sink". Opinions vary with WoodMackenzie saying most shales can be drilled for profit at $50, but the consensus seems to be more like $60. However improving technology has this breakeven point edging down. The point is that we could see a very nice rally in oil from $38 and still see a very dangerous wave of bankruptcies in the months ahead.

This basic problem is borne out by a credit downgrade/upgrade graph the AdvisorShares article shows:

This is for all sectors, but as we all know, the vast majority of problems are in energy. The gray bars show the companies that have been downgraded from investment grade to high yield while the blue bars show the companies that have been upgraded out of high yield to investment grade. It is very bearish to see that 2015 saw an extreme level of credit downgrades only matched in 2002 and 2009 - the two worst previous bear market years. There is a 3 month lag between downgrades and the additions to this index. So there could be a lot of late 2015 downgrades yet to be added to the 2016 total. 

What is truly scary is that the downgrade bar we see for 2016 is just for the first quarter of this year! This rapidly deteriorating credit situation may be much more significant than any $10 move in oil. We seem to want to feel safe if oil pokes its nose above $40. But, even if oil stabilizes at $40-$60, where it has resided for all but 3 of the last 16 months, we could still see a continuation of this:

was a big deal in 2002 and in 2009 in the downgrade graph above. It was associated with the two previous horrendous bear markets. And that seems to be the market's opinion now. If you look at the XLF (US financials) you see that they are lagging this rally of the last couple months very badly. And the non-US banks are lagging much worse.The market seems to think they are a big deal.

End Or Beginning Of A Bear Market ?

In the downgrade chart above, the previous downgrade fiascos of 2002 and 2009 were years at the end of bear markets. Are we there now? Well, let's see.We are within about 3% of the all time high on the Dow. The Fed is jawboning a normalization of rates because the economy is so good. And the 2016 credit downgrade total looks to be at least 4 times as bad as 2015 with nil upgrades compared to any year in the past. Looking at the graph, downgrades fell precipitously in the years following '02 and '09. They are rising sharply this year. Call me crazy, but I'm saying it's more like the beginning of a bear.