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The Junk Bond Market's Message is Loud and Clear

Investors were highly complacent just before the recent big jump in stock market volatility

by Bob Stokes
Updated: May 16, 2019

As noted before in these pages, the Elliott wave model is a direct reflection of the repetitive patterns of market participants. The psychology of the "crowd" swings from optimism to pessimism and back in a natural sequence.

Hence, if sentiment measures show extreme pessimism, expect the start of a swing toward optimism to begin, sooner or later. If investors are highly optimistic, that's usually not the time to place big bullish bets because the start of a bearish trend is often just around the corner.

With the above in mind, consider the notable investor optimism in the total return of the lowest-grade debt. Here's a chart and explanation from our May Elliott Wave Financial Forecast:

Junkier

U.S. junk debt gained over 8% through the first four months of the year, which is the best start to a year since 2009. The graph shows the total return since January 2018 in U.S. CCC-rated bonds, which are junk, and U.S. AAA-rated bonds, which carry the highest investment-grade rating. Observe that when stocks plunged from October to late-December of last year, the total return on investment-grade debt exceeded the total return on junk debt as investors sought safety. The decreasing disparity between the return on junk debt relative to investment-grade debt now shows the opposite: a high level of optimism toward riskier financial assets.

Our observations over the years show that junk bond complacency usually correlates with stock market complacency.

Indeed, on April 24, a Bloomberg headline said:

Stocks at Record Highs Hold a Lot of Appeal

That's why our subscribers were not surprised by the recent stock market selloff, considering the high-degree of financial optimism that was in place.

By the early morning hours of May 13, Bloomberg had an entirely different headline:

S&P 500 Futures Tumble, Extending Worst Weekly Drop of 2019

As you probably know, by the end of the trading day on May 13, the S&P 500 index sank nearly 70 points, which was its 15th-biggest point decline in history. The DJIA plummeted 617 points.

The question now is: How long will the volatility last?

Junk bonds are just one market that sends a loud and clear message to help you answer this question. In fact, we track over 100 different market indicators, many of which you won't find discussed in the mainstream financial press.

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