A Big 'Test' for the Market
A big 'test' for the market... The first sign of a bottom?... Keep an eye on 'junk' bonds...
For the past several weeks, we've warned that stocks weren't 'out of the woods' yet...
We expected the broad U.S. market to revisit its February lows – or possibly make an even lower low – before the bull market resumed. And one of the biggest reasons had to with an indicator known as the 200-day moving average ("DMA").
If you're not familiar, the 200-DMA is exactly what sounds like... It's simply the average price of an asset over the past 200 days. Averaging prices over many months helps to filter out short-term price volatility, and makes the 200-DMA a useful (if rough) gauge of the market's long-term trend. As we explained in the January 17 Digest...
During bull markets, stocks tend to spend most of their time above the 200-DMA. During bear markets, they spend most of their time below it. And perhaps most important, stocks rarely stray too far from this line in either direction before returning to it.
The following chart of the S&P 500 Index shows how it works. As you can see, since stocks moved back above this trendline following the financial crisis in 2009, they have rarely traded below it...
As we noted at the time, whenever stocks have rallied significantly above the 200-DMA, they've eventually come back to "test" it – touching it or even moving below it briefly – before continuing higher. And the market was long overdue for one of these tests...
Right now, the S&P is nearly 12% above the 200-DMA. And it hasn't "tested" it in more than a year.
This is unusual... In fact, the market has only been this stretched above the 200-DMA three other times since the rally began. And each of those cases preceded a sharp correction over the next few months.
We warned that it was simply a matter of time before the market reversed lower.
Of course, we know now that the market peaked just two weeks later on January 26...
The S&P 500 Index proceeded to fall more than 10% over the next 10 trading days, pushing the market into official "correction" territory for the first time in nearly two years.
Meanwhile, the market's "fear gauge" – the CBOE Volatility Index ("VIX") – quickly spiked from around 10 to almost 50. This is the type of panic that often marks the end of a decline.
But again, we remained cautious... And one of the biggest reasons was because the market had still not tested the 200-DMA on a closing basis.
Today, we can report that this is no longer the case...
As you can see in the following chart, the S&P 500 closed right on this key trend line on Friday, and reversed higher today...
This is a bullish sign.
To be clear, this doesn't mean that we can't or won't see further downside. As you can see in the long-term chart above, the market sometimes "overshoots" on the downside as well. We could still briefly dip below the 200-DMA before reversing higher again.
But for the first time since the market peaked in January, we now have all the necessary requirements for a meaningful bottom.
The market is trading well above the 200-DMA as we write... Should it close in positive territory today and continue higher this week, the odds of a successful test will rise dramatically.
But this isn't the only indicator we're watching right now...
Longtime Digest readers know the high-yield (or "junk") bond market can be a powerful "leading" indicator for stocks. Our colleague Ben Morris reviewed this relationship for his DailyWealth Trader subscribers last week...
Junk bonds – also called high-yield bonds – are interest-bearing loans issued by companies with weak financial positions. Because the risk of these companies not paying you back is relatively high, these bonds pay higher interest rates than the bonds of financially strong companies. Junk-bond investors take on more risk... So they expect higher yields.
Bond prices and bond yields move in opposite directions. So when junk bonds perform well, corporate borrowing rates fall.
Low rates are great for borrowers... especially the ones who need it the most. Lots of lower-quality companies rely on borrowing – including the ability to refinance their debts – for their businesses to stay afloat or grow.
In other words, high junk-bond prices and low borrowing rates are usually a good sign for stocks...
On the other hand, when junk-bond prices fall and borrowing rates rise, it often leads to trouble for stocks. More from Ben...
Most often, this happens when a wave of companies default on their debts. Bondholders take big losses... And new investors are reluctant to buy. So rates go up. Again, they sense more risk. So they demand higher returns.
This makes it more expensive for companies to refinance old debt and to issue new debt. And sooner or later, this filters into share prices. But it can take months, or even years, to play out...
Because junk bonds are the riskiest of the bunch, they often feel the pain first. So we can monitor junk bonds as an early indicator for stocks.
This is what happened before the last big correction in stocks back in 2015...
Ben showed how this dynamic played out using our favorite proxy for the junk-bond market: the iShares iBoxx High Yield Corporate Bond Fund (HYG)...
In the chart below, you can see that HYG shares (the black line) peaked in June 2014. Then they turned lower and started a new downtrend (or a series of "lower highs" and "lower lows"). This was the warning flag.
The benchmark S&P 500 Index (the blue line) then topped out in May 2015 – nearly a year after HYG peaked. And after it did, it plunged, bounced, and plunged again... all while junk bonds continued lower. If you look closely, you'll see that junk bonds hit a new low well before stocks tumbled for the second time...
At their February 11, 2016 lows, HYG and the S&P 500 were down 21% and 14.2%, respectively, from their peaks. And the downtrend in HYG warned alert investors that it was coming.
And as Ben explained, we could be seeing something similar today. Junk bonds and stocks have been diverging for months. More from the issue...
As you can see below, HYG peaked on July 26 and has been in a downtrend ever since. The S&P 500 peaked six months later – on January 26. It has recovered some of its losses. But it hasn't made new highs...
So what should you do with this information?
Ben laid out what he'll be looking for in the coming weeks to gain insight into the market's next big move...
If HYG turns higher and starts a new uptrend, it shows the junk-bond market is stabilizing. And stocks will be more likely to break out to new highs.
We'll likely add new positions in the strongest sectors, like technology and financials. And stick with our "trading for income" plan of selling options on great businesses trading at good prices.
If HYG continues lower, we'll take a more cautious approach. As investors will raise concerns about rising borrowing costs, stocks will be more likely to break down to new lows.
In this case, we'll likely take fewer long positions and add more short positions for some insurance.
For now, our advice remains the same...
Stay long, but stay smart. As Porter explained on Friday, proper risk management is critical no matter which way the market moves next...
Successful investing is more about managing these risks than finding winners. Unfortunately, that's something most investors will simply never understand. But you can. It's really not hard...
In short, if your portfolio isn't doing well, it's time to look at your asset allocation. It's time to figure out how to hedge your risks. And it's time to carefully consider your position sizing. If you haven't yet, please take a free trial subscription to TradeStops. If you do nothing else, at the very least begin to manage your position sizes with its volatility-based position-sizing algorithm. For most investors, this is the single most powerful tool you can use to improve your results.
New 52-week highs (as of 3/23/18): short position in Sprint (S).
In today's mailbag, several subscribers respond to Porter's Friday Digest request. Let us know how you're doing at feedback@stansberryresearch.com.
"Porter, I just read your Friday Digest. I started using TradeStops about a year ago it has helped with how much to put into a stock or fund to reduce my risk. It has helped way beyond what I had hoped.
"I checked my portfolio this morning as I do each week to see what it has done in the past week vs the previous week or month vs what the top ten stocks in the S&P 500 index that I track... Was surprised to see I was down about 4.5% vs the S&P stocks at 9.5%. I am trying to learn from what you are teaching, so far it is working. Keep up the hard work. Thanks." – Paid-up subscriber Joe B.
"For us the news is still good. Starting almost three years ago to the day, the value of our portfolio has slightly more than doubled. Recently we had a more volatile performance, with the peak of our value on1/29/18, at 142.5% above our starting point. We held several positions (with our fingers crossed) thru year-end, and closed them out on 1/2/18 for a total return of $148,000 to start the year. Our low point was 2/8/18, when our early gain was reduced by 21.13%, but is now recovered slightly more than 6%, including today's bloodbath.
"Along the way, we trimmed the portfolio to increase our cash to just under 50%, but when we see the bottom of this correction in our rear view mirror, we plan to invest significantly in Steve's [Melt Up Millionaire portfolio], for the last of the 'Melt Up,' and put a few hedges in place, using Porter's 'Dirty Thirty' and other positions that lend themselves to long term 'leaps'. We hope to recover the rest of our recent correction loss using this formula, and be ready for the end of the Melt Up whenever it appears. Thanks to Stansberry Research, especially Doc, Steve and Porter, we enjoy true financial stability in our lives." – Paid-up Stansberry Alliance members John & Barbara, celebrating 50 years together in April
"The broad market was down around 2.5% today. My portfolio lost about 1.5%. It is made up of the Income Portfolio, some Melt Up stocks, a few precious metals stocks, a covered call or two, and a couple of Sjug's special situation trades. Still sleeping quite well. Thanks for the restful nights." – Paid-up subscriber Mike P.
Regards,
Justin Brill
Baltimore, Maryland
March 26, 2018