Early Warnings Of A Stock Slip

Sometimes, avalanches begin with the dislodgement of a single pebble. Equity investors are now wondering if the underpinnings of the bull market are loosening. While stock indices still seem to be reaching for new heights, once-niggling cracks are starting to widen on its footholds.

Take high yield bonds proxied by the ProShares Short High Yield ETF (NYSE Arca: SJB) as an example. SJB provides investors with unlevered short exposure (-1x) to a market-weighted index of corporate high yield (read: “junk”) paper with maturities between 3 and 15 years.

If you trace the path of equity prices, most particularly the S&P 500 Index as tracked by the SPDR S&P 500 ETF (NYSE Arca: SPY), against SJB’s value you’ll see a mirror image. As SPY rises, SJB tumbles. Check that. It’s really the other way ‘round. SJB’s really the leading edge of stock market trends. Why? Because junk bonds are exquisitely sensitive to the pitches and rolls of corporate balance sheets.

The ups and downs in SJB’s price are “tells” because stocks and junk bonds have, you should forgive the pun, so much in common. Both asset classes are low on the claim ladder for corporate earnings and liquidation proceeds. Owing to their heightened sensitivity to default risk, bonds tend to react first, though.

(Click on image to enlarge)

See the recent upturn in SJB?Yeah, that’s right. The blip in the lower right-hand corner. It’s a breakout from the ETF’s two-year downtrend. The SJB early warning klaxon seems to signal trouble ahead for stocks. As reliable as the SJB trend has been in the past, though, we ought to look for some confirmation elsewhere.

The equity market’s appetite for risk has always been a dependable signal of sentiment change. You can divine this by taking the ratio of the PowerShares S&P 500 High Beta ETF (NYSE Amex: SPHB) to the PowerShares S&P 500 Low Volatility ETF (NYSE Amex: SPLV). A higher ratio indicates investor enthusiasm for the most volatile issues in the S&P; a lower ratio heralds defensiveness. As you can see in the chart below, recently established support for the ratio seems to be breaking down now.

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Disclosure: Brad Zigler pens Wealthmanagement.com's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) option ...

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