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Chart In Focus

Strength in Hi-Yield Bonds is Bullish For Stocks

Chart In Focus
October 08, 2010

Lots of different asset types compete for investors' attention.  When people have a choice between investing in the bonds of corporations or the stocks of corporations, it might seem like a zero-sum game, where one would do well and so the other would suffer.  But in reality, it is a positive sign for the stock market when corporate bonds are doing well.

This is especially true when looking at high-yield corporate bonds, which are riskier investments because of the potential for default by the companies backing those bonds.  Because of that greater risk, high-yield corporate bonds are among the least-deserving assets of investors' attention, and so there is a strong message at times when they are doing well.

This week's chart compares the SP500 to the Mainstay High Yield Corporate Bond Fund (MHCAX), which I chose as a representative of that category of funds.  It gives a good representation of what high yield bonds are doing overall. 

The interesting point to take from this comparison is that when MHCAX is doing well, it tends to be a good time for the SP500.  And when MHCAX is in a downtrend, it tends to be a bad time to invest in the stock market. My explanation for this is that high-yield bonds can only do well when liquidity is plentiful, and so seeing them do well is a sign that there is good liquidity for the overall market.

Right now, MHCAX and other similar high-yield funds are moving ahead to higher highs, which is something that the SP500 has yet to accomplish. If we were instead seeing a divergent lower high in MHCAX, like the ones we saw in 2000 and 2007, that would be a really worrisome sign for the market.  But the statement for right now is that the stock market is in an uptrend and should continue to rise for the foreseeable future until the high yield bonds show that they are running into trouble.

Tom McClellan
Editor, The McClellan Market Report