June 8, 2018
By Steve Blumenthal
– Rudyard Kipling
It was Kipling’s poem. A reflection. A smile. And yes, a tear. It was my mom whispering. If I could share some advice to the young CFA, an advisor, my client, my friend, my kids and again to myself… that poem. So much in that poem.
This week, I share with you a few general observations about the high yield bond market. A market I know quite well. And in it some clues for us to follow. Signals, if you will, that might help light the way. Today’s piece is a story about “If,” and what I see coming on the horizon ahead.
To begin, I’ve been trading the general trends in the HY space since the early 1990s. As a rule, HY tends to be an excellent economic indicator generally leading the turn in equities and the turn in equities tends to precede recessions. The bad stuff happens in recession. We will take a look at what the trend in the HY market is telling us.
To give you a feel for what we will look at today, one of the indicators I look at each week plots the trend in the S&P 600 Index (small-cap stock index). The process looks at just two things:
- Is the S&P 600 Index above its 36-day smoothed moving average?
- Is the S&P 600 Index advance-decline line above its 40-day smoothed moving average?
- If both are above, as you can see in the next data set, HY bonds gained 16.05% per annum. When mixed, they gained just 0.38% per annum and when both were below their respective smoothing lines, HY bonds lost 19.09% per annum. (Important to note that this is only the price performance of the Barclays U.S. Corporate High Yield Price Index and doesn’t include the yield, so total return in positive periods would be much greater and losses when both are below the MA would be better.)
- The point is the impact on price and how small-cap stock trends can be a great indicator for HY bond market performance. The point is this process can help us risk manage both HY and equity portfolio exposure. The shaded area marks the current regime. Both are above their moving average… that’s good news for now.
- One last note, both the price line and the advance-decline line were above their smoothed MA 50.41% of the time and both were below about 33.48% of the time. The data is back to 1995. It’s when they are both below, that things should start to get interesting.
Our current starting conditions find us in the elevated risk zone: high debt, low bond yields and near-record high equity market valuations. While the global economy is on sound footing, inflation is picking its head up and that will likely keep the Fed on the path to higher rates. Late business cycle stuff… The grand experiment will be tested. We watch.
For a deeper dive, my overall view is summarized in a piece I wrote called, The Debt Bubble and the Interest Rate Trigger. But I’ll save you some time, in short, the move to higher rates will pinch the economy, recession will follow, taking the Fed’s batting average from 10-for-13 to 11-for-14… meaning the last 13 times they’ve hiked interest rates, we’ve landed in recession 10 times. Rising inflation and rising rates will threaten economic growth and earnings potential making the excessively high price-to-earnings ratio unjustified. Equities declined 50+% in the last two recessions. The next one may be equally as challenging or maybe more.
As I think about the high yield market and the signal it may send and reflect back on where we sat pre-subprime crisis in 2008, I recall what Kipling’s “If” poem meant to me then and share with you the tear I shed listening to it again at my son’s pre-graduation service. Words that helped me in’08. Wisdom gifted me from my mom many years ago. Rewritten by my daughter on poster board and taped to our refrigerator. Words that helped me then. Words I continue to hold close to heart.
Grab a coffee and find that favorite chair. Keep a close eye on the trend in HY. Below you’ll find a few ideas as to how. High yield will be the next subprime and I believe we can navigate the way. And jump to the personal section for the “If” story.
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Included in this week’s On My Radar:
- The Trend in the HY Bond Market
- Trade Signals — Moderately Bullish Equity Trend, Fixed Income Bearish, HY Bond Trend Bullish Once Again
- Personal Note — Kipling’s “If,” Graduation and Family
The Trend in the HY Bond Market
The black line in the next chart shows the price line of the Barclays U.S. Corporate High Yield Bond Index. Just get some footing on the movement of the line over time. Also, take a look at the red “We are here” arrow and simply note that the recent trend has been down since late 2017. The idea is to get a sense of the overall trend.
The blue line in the chart above is the total return line. High yield bonds pay a higher interest rate but with higher risk. Junk is in the name for a reason as these companies run a higher risk of default. They tend to have more leverage (debt) relative to income so the risk is higher.
The red line at the bottom of the chart shows the current yield to worst (slightly above 6%). You can see the all-time low was 4.95% in 2013.
What I really want you to focus on is just how much prices declined in the 2008 crisis (black line middle of chart) and just how much yields increased. If you were short HY, a home run. If you were in cash and bought in for 22.97% yields coupled with the price gains that followed, a bigger home run.
And that’s my point. If I’m right and high yield is the next subprime, can we be positioned for that gain? I think we can as you’ll see next.
Since the early 1990s, I’ve been trading the trend in the HY space. HY trend is fairly predictable. While not all trades are perfect, the batting average or win rate is pretty high. The next chart looks at a simple moving average of the price of a high yield bond fund. In this case, I show the PIMCO High Yield Fund and reflect a simple moving average price line.
When the price moves above the slower moving average price trend, a buy signal occurs. When it moves below, a sell signal occurs. Here I plot a simple 50-day moving average price line (the thin black line) vs. the price line that zig zags in red and green. It looks like this:
Note the yellow highlighted areas 2001-2002 and 2008-2009. Also, note the “we are here” arrow showing the current move above the 50-day MA line. A buy signal by this measure.
Bottom line: I feel confident about the coming blow-up in HY. The junk bond market has never before been loaded with such junk and with little protection to us bond holders. I believe the next crisis will be epic, creating the greatest opportunity in my nearly 27 years of trend following HY. But despite this belief, timing is tricky but so important. Thus, have a process that works for you. I suggest a simple moving average rule can help and is needed more today than ever.
Finally, next is another process I keep my eye on. I mentioned it in the intro and share it in more detail, with Ned Davis Research’s permission:
Here is how to read the chart:
- Buy signals are generated when the price of the S&P 600 Index (small-cap stock index) is above its 36-day moving average line (middle section of the chart) and the advance- decline line of the same small-cap stock index is above its 40-day smoothing.
- Sell signals are generated when both are below.
- Data from 1995 to present reflected in the box at the bottom of the chart.
- Currently both are above.
Bottom line: The trend for HY is currently positive. There are tools we can use and processes we can follow that can help us risk manage the journey ahead. We’ll look back at high yield like we did subprime post-crisis ’08. And the opportunity will be epic. My two cents anyway… no guarantees, of course. Let price action help us with timing. Trend following can help.
And speaking of journeys, just after the trade signals section, I conclude with a personal story about a poem and family and life. About “If.”
Trade Signals — Moderately Bullish Equity Trend, Fixed Income Bearish, HY Bond Trend Bullish Once Again
S&P 500 Index — 2,769 (06-07-2018)
Notable this week:
The longer trend models for equities (Ned Davis Research CMG U.S. Large Cap Long/Flat signal remains moderately bullish as does the 13-week EMA vs. 34-week EMA trend signal). CMG’s short and intermediate CMG Tactical All Asset and CMG Tactical Equity models remain defensively positioned in Treasury Bills — something we have not seen in the history of the models. Equities remain above the important 200-day MA line while the yields on the 10-year and 30-year Treasurys remain below 3.07% and 3.22%… important levels to watch. The Zweig Bond Model remains in a sell signal for high quality fixed income. HY moved back to a buy signal.
Several weeks ago I shared the following chart. The red line is the 200-day MA line. It held three times and recently broke out to the upside. The trend remains positive.
However, it would be nice to see the number of stocks in the S&P 100 Index above the 65% line. Bull markets are strongest when a majority of stocks are sending the averages higher. One rule some traders use is to de-risk from stocks when the percentage of stocks above the 200-day MA line drops below 65% and move the balance of stock exposure to cash when less than 50% of stocks are above their 200-day MA lines.
Bottom line: The overall weight of evidence continues to support a moderately bullish market outlook. Yet, keep in mind that the cyclical bull is aged and valuations are high.
The next section walks you through all of the Trade Signals charts.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is firstname.lastname@example.org. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note — Kipling’s “If,” Graduation and Family
Things were starting to crack in October 2008. By Thanksgiving, it was clear that the subprime mortgage debt infection had taken hold. Calm first, then panic. By February, panic ruled over reason, as investors looked for liquidity everywhere. Every investment management firm and every advisor (I’m sure you as well) were in crisis mode.
My daughter, Brianna, knew something was wrong. Then 15 years old, she rewrote the words of Rudyard Kipling’s poem, “If” and gave it to me. Sensing my stress, Brianna artfully wrote the words on a poster board for me. She copied from a framed print of the same poem my mom gave to me when I was a young boy. On our refrigerator hung Kipling’s poem. I read it every day for months:
As I sat in the pew in a beautiful church last night, part of youngest son Kyle’s graduation service, one of his classmates read Kipling’s poem. Advice to his classmates. I smiled… It took me back. I thought about the lessons that lie ahead for Kyle and his friends, I thought about the challenges in ’08, I remembered that wonderful poster Brie gave to me and I said a prayer to my beautiful mother. I smiled, teared and returned my attention to Kyle.
And women dear Brianna!
This morning, Kyle and his classmates graduated from high school. Boy, does time go by too fast. “The days are long, but the years go fast,” a parent said to me. Indeed. By the time you are reading this I will be deep into celebration with the people I love the most. And the party continues… A big family dinner is planned for Sunday evening and a lunch celebration follows stepson Connor’s graduation on Monday.
I think my mom was right. Could she have possibly known how far Kipling’s poem would travel? And Kyle’s classmate… Work hard and win with grace. Hold on with the Will which says hold on and fill your life with sixty seconds’ worth of distance run… yours is the Earth and everything that’s in it… Amen.
Grandma Pat has been here for a week and what a treat she is. Pictured are Pat, Susan, me, Brie, Kyle, my ex-wife Jan and son Kyle. Susan’s son Tyler is two weeks into Officer Training School and Connor and Kieran are at school. I’m checking in happy and extremely grateful. Wishing you the same and more…
Travel picks up again in the next few weeks. I’m in NYC next Monday and again Wednesday for meetings (that includes an invite to a Yankees game). I do root for them as long as they are not playing against my Phillies. My old man brainwashed me a long time ago… all things Philly (including the cheesesteaks). And speaking of cheesesteaks, if you have been to Philadelphia, you’ve probably been to South Philly. South Philly is famous for its rival steak shops Pat’s and Geno’s. They are competing businesses set right across from each other and both do exceptionally well. Lines are always around the block and you better get your order right or else you get some edge from the order taker. My new favorite is Steve’s Prince of Steaks in Center City. Pat’s has dropped to the number two spot. Order yours with cheese whiz. That may be the next destination for our summer intern. Lunch is important around here.
St. Louis follows at month end and we have planned a trip to Hawaii for mid-July. I’m finally taking up a gracious offer from a longtime friend to stay at his Maui house. Susan and I and our gang of six will take some time off in July and enjoy our time together. I’ve been holding off on purchasing the tickets due to the volcano issues on the big island, but it’s time to book. I really can’t wait. Some downtime is needed. Excited and grateful.
Ok, that was a lot about me. Sorry my friend… Hope you are enjoying your family and have some fun vacation plans in your near future.
Have a wonderful weekend. Wishing you the very best.
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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