Junk Bond Spreads The 4th Tightest To Start A Year Since 1998

2018 Starts Off With A Bang

The stock market is looking like it’s about to do the impossible, have a repeat performance of 2017 which was in the 99th percentile in terms of risk versus return. The first two days have been great. In the S&P 500, the first two days of 2017 were up 0.85% and 0.57% and the first two days of 2018 were up 0.83% and 0.64%. The closeness of these results is probably a coincidence, but it’s notable. On Wednesday, the S&P 500 hit another all-time high. The VIX was crushed as it fell 6.35% to 9.15. The chart below shows the historical two day movements in the Nasdaq 100. As you can see, this is third best move in the past 1.5 years. The stock market is extremely overbought. I expect a selloff next week as all traders come back to work. The CNN Fear and Greed index is at 67/100 which means greed. Since the year has started off good, the stats on winning streaks to start the year have come out. The longest positive streak to start the year is 7 days which occurred in 1976 and 1987.

As someone who focuses on macroeconomics and the fundamentals of corporations, I’m not one to go by Wall Street adages such as ‘sell in May and go away’ or the fact that January’s performance predicts what the rest of the year is going to look like. That being said, the Santa Clause rally did occur last year and the chart below shows January’s prediction record is solid. As you can see, January’s return buckets perfectly align with returns in the next 11 months, dating back until 1971. With the first two days in the books, the month is looking like it will be positive. As I said, I think the market is due for a selloff next week, but I can’t include a prediction in that analysis. The other factor which might affect stocks in the next few days is the winter storm. Home Depot stock was down on Tuesday, but it was up 0.52% on Wednesday as the storm approaches. The repair firms will be helped and the retailers will be hurt if the storm, which will impact the east coast, is bad. The economic data will be worthless in January if the storm hurts results.

Junk Bonds Are Expensive

The Bank of America investment grade credit spread is at 98 basis points which is the tightest since June 2007. The table below shows the options adjusted spread of high yield bonds. I find it interesting that there is so much analysis done on how stocks perform after they have a great year, but there’s not much done on what happens after high yields have a great year and are tight. As you can see, the spread to start 2018 is the 4th lowest in the past 20 years. If you look at every year in this list that had a spread below 400, spreads increased 3 out 4 times in the next year. That’s not a guarantee spreads will increase, but there’s a lot of downside in high yield debt and not a lot of upside. If you go long junk bonds, you are picking up pennies in front of a bulldozer.

Closing In On The Second Longest Expansion

The story of the year will be how long this expansion has been going even if the economy looks strong throughout the year. The chart below shows this will be the second longest expansion if it lasts another 2 quarters. The chart shows data since WWII, but this expansion will be the 2nd longest going back to 1854. As I’ve said, the yield curve will get a lot of press as it closes in on an inversion. The two things to keep in mind are that it’s not bearish to be near an inversion and that it’s not different this time. Prognosticators often have narratives they need to support. Bears need to claim the flattening is a sign of a recession. The reality is recessions usually don’t immediately occur after the inversion, so getting bearish before it inverts would be too early. It’s possible, the inversion doesn’t occur this year. Don’t get confused between facts and opinions. The yield curve can invert, but it’s far from a guarantee. Once it inverts, the bulls will claim it doesn’t matter. I know this because there are already some making that point. Currently, the difference between the 10 year and the 2 year yield is 51.58 basis points. It has been in a sharp downturn, but there have been corrections in this trend which delay the path to an inversion by a few months.

Liquidity Forecasted To Dry Up

The reason almost every global market did well in 2017 besides the improvement in growth is because there was excess liquidity. As you can see from the chart below, the All Countries World Index has tracked the global excess liquidity index when the liquidity is 12-14 months ahead. This makes it a good leading indicator. In the past year, The ACWI was up 21.62%. With the year over year chance in liquidity falling to the negatives, it looks like global stocks won’t have a repeat of 2017 in 2018.

Small Caps Underperform In 2017

The Russell 2000 was up about 13% which was worse than the other major indexes. The chart below reviews the performance in each sector broken down by the size of the firms. As you can see, small caps only beat large caps and mid caps in healthcare. If you thought energy stocks did poorly in the S&P 500, look at how the mid cap and small cap energy stocks did. Small cap energy firms were down 26.7%. This could be an opportunity because oil prices have been increasing and energy stocks typically do well at the end of the cycle. The best buying opportunity will be when oil falls in the next few weeks because everyone and their mother has a net long position in it. It’s also notable how small cap financials had a weak 2017 after they rallied right after the election.

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