High Yield Meat (HYG,SLV)
Some assumptions are safer to make than others.
Until recently, for example, it was assumed that the financial markets would automatically be backstopped by the Federal Reserve and Treasury at the first sign of distress. After all, we went through several rounds of Quantitative Easing, state-initiated bond purchases, government directed corporate bailouts and more over the last seven years, so why shouldn’t the process continue?
Well, it seems some at the Fed and in Washington now believe that the stimulus has to end. With interest rates projected to bump higher several times in 2018 and the gradual reduction of the Fed’s balance sheet already commenced, all indications are militating against the type of intervention we’ve become accustomed to since the bull market began.
And the result is a market that’s showing increasing signs of worry that we’ve entered risky waters.
We, too, have begun to ask of late if the financial world has grown a wee too complacent, or if, in fact, the current worry will only serve as a distracting backdrop for further screaming gains into the New Year.
And it led us to the following.
First, consider the following chart of the junk bond market – among the riskiest corners of the investment panorama – as represented by the iShares iBoxx High Yield Corporate Bond ETF (NYSE:HYG).
The chart compares HYG with the S&P 500 for the last two years. And the relative performance is stark.
The high yield market has done essentially nothing since the summer of 2016 and has traded in a very narrow range for over a year now (red price channel).
The S&P 500, on the other hand, needs no comment. The outperformance there has bested even the most bullish commentators (in green).
Our own feeling about the relationship between high yield and overall equity performance is as follows.
First, where high yield leads, stocks will follow. There’s little doubt about this as it’s a pattern that has borne itself repeatedly over time.
And if that’s the case, whither high yield?
Are we now witnessing the ‘pause that refreshes’ for that asset class, or are we in the midst of a topping pattern that leads into a mortal decline?
Our preference is to put our faith in the technical picture here. And because the high yield pattern has persisted for so long, we aver that the next big move will be determined by the direction HYG resolves its current sideways slide. That is, a break below the low end of the channel will signal a lot more selling in store, while a break higher will presage a hefty climb.
And, of course, equities will follow suit.
We would also add the following…
That the options market is betting decidedly on a very steep drop to come in the junk market.
With HYG trading today at exactly $87, the at-the-money CALL and PUT prices for three, six, nine and twelve month expiries are all weighted heavily on the PUT side.
Here, for example, are the premiums for next December’s ATM options (in red) –
As you can see, traders are betting massively on the probability that high yield values plummet in 2018.
And we would agree with that orientation, with one reservation.
While it’s very probable that HYG will experience a downdraft in the next year, it’s very difficult to predict 1) when precisely that will happen, and 2) what might trigger it. The first is important for those who would short the shares or purchase PUTs, and the second for those who want to anticipate the timing of such a move.
And we’re going to discuss that issue directly after we report on the following…
We’re going to close one trade this week, our December 12th initiative, from a letter called Bitcoin and the Irony of ‘Real’ Money. There, we urged you to consider selling the SLV June 29th 16 CALL for $0.49 and buying three (3) June 29th 13 PUTs for $0.17 each. Total debit on the trade was $0.02.
And whaddaya know…
Today, the CALL goes for $0.63, and the PUTs trade for $0.09. Sell the former and buy back the latter and you step away with $0.34 on two cents down. That’s a profit of 1700% in just two weeks. And that calls for a brutally erotic Swedish massage from Demona Borgnine, queen of the fat fingered rub –
Time for a trade, friends.
We’re currently surveying the investment landscape for signs of where a potential breakdown might occur in the short term that would push the high yield market out of its current range. Remember, where high yield goes, so, too, likely equities.
And it appears to us that the greatest potential for danger comes from the energy market, where not only Mideast tensions, but North Korea and the Russia-Ukraine conflict seem ever closer to bursting into a hot war.
The following chart depicts the fears fund managers consider most likely to derail the current equity bull –
There are a number of fears that emerged on the radar this month, but our focus is on the Middle East ratcheting up a notch.
Should that happen, we would likely see a sharp rise in energy prices and a concomitant swift jerk in the high yield sector.
But in which direction, it’s hard to say.
So for that reason, we are going to play it both ways.
In the first place, we’re gaming the junk market to make a dive sometime in the next thirty days, but to recover and climb higher over the longer term.
And that means we act as follows …- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
Wall Street Elite recommends you consider buying the HYG January 18th (2019) 89 CALL for $0.52 and selling the HYG January 18th (2019) 75 PUT for $0.95. With the $0.43 credit we would advise the purchase of the HYG January 26th (2018) 86.50 PUT for $0.39. Total credit on the trade is $0.04.- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
With kind regards,
Hugh L. O’Haynew