When people run away from it, what will be the next?

I have talked about junk bonds before, which are risky debts that companies with low rating issue to raise fund for their business. As we often hear, high risk, high return. Given the less security involved for junk bonds, the interest rate is much higher that the more secure bonds. So people hungry for income are very interested in the junk bonds, especially in the current almost zero interest environment. But here is the thing, those junk bond investors are very sensitive to the risk and they are almost always the first ones to run when they start to feel unsafe. That’s why junk bonds tend to lead the stock market by a few weeks to signal the next potential direction. In other words, when junk bonds start to fall, you should be worried what will come for the stock market.

For most of the passed months this year, the market has been extremely calm without any fear as I talked about before. So the junk bonds (HYG) has been in a very strong uptrend and moved up 9% for the year to date. This is quite a big move for bonds you need to understand. But if you decipher it a bit based on its weekly chart, you should notice that for most part of this period, roughly starting from March, a strong negative divergence has emerged in both of its relative strength (RSI) or the momentum indicator (MACD). This is an early warning sign that the current uptrend is going to end. Now for the first time in the past 8 months, we start to see a crack as well in its price actions. It has broken down from its uptrend. This is especially significant when shown up in the weekly chart as it suggests a long term trend developing for the junk bonds. While I don’t mean it will happen immediately, I have a strong feeling that the junk bonds will fall fast in the weeks ago and at least down towards its 50 day MA about 4% from here. If this indeed materializes, it means traders are running away from the risky assets. So what will be the next? A big storm for the stock market may come soon after that!  Following some big drops, the market would try to bounce back for a while. Don’t be fooled by the dead cat bounce for the stock market, friends! The bounce could be quite strong to fool many people into a euphoric mood again and then it may fall apart suddenly, only more severely. Just remember what the stock market is good at: make as many people as painful as possible. Try not to be one of them!