The “junk spread” is currently at historically low levels, suggesting an increased risk of an impending recession. This spread is defined as the difference between the yield on corporate high-yield bonds and comparable U.S. Treasurys. It represents the additional yield that investors require to compensate for the higher risk associated with investing in junk bonds instead of Treasurys.
Currently, the spread stands at 3.5 percentage points, well below its long-term average of 5.4 percentage points since 1997 (see chart). This indicates that investors perceive economic risk to be abnormally low at the moment. This sentiment aligns with the widespread belief that the U.S. Federal Reserve has managed to achieve a smooth and controlled economic slowdown.
However, as Humphrey Neill, the pioneer of contrarian analysis, famously said, “When everyone thinks alike, everyone is likely to be wrong.” Contrarians argue that the current low spread reflects an excessive optimism that will eventually correct itself in the coming months.
Historical data strongly supports this contrarian viewpoint, as illustrated in the table below. The results presented are based on the ICE BofA U.S. High-Yield Index Option-Adjusted Spread, which is one of the widely recognized measures of the junk spread.
| Year | Spread | |——|——–| | 2001 | 6.2 | | 2002 | 8.1 | | 2008 | 20.4 | | 2009 | 16.8 | | 2015 | 5.9 | | 2016 | 4.7 | | 2019 | 3.5 |
In summary, the currently low junk spread indicates a potential danger in the market. While investors may currently perceive a low level of economic risk, historical evidence suggests that this sentiment may be misguided. Considering the contrarian perspective, it is essential to remain cautious and anticipate a possible correction in the coming months.
The Significance of the Junk Spread
The chart presented below offers valuable insights into the current market conditions. It provides statistical evidence which indicates significant differences at a confidence level of 95%. This level is commonly employed by statisticians to determine the authenticity of patterns. The chart’s first row represents the lowest historical quintile, where the junk spread currently resides. This particular positioning leads contrarians to suggest an increased risk of a recession.
Elevated Risk and Economic Impact
A rise in the junk spread ranging from 1.9 to 4.8 percentage points over a span of one to two years holds great importance. Not only does it symbolize heightened economic risk, but it also exacerbates the overall risk level. Such an increase further contributes to the potential severity of the situation.
A Longer-Term Indicator for Contrarians
Contrarians, therefore, should incorporate the junk spread into their repertoire of sentiment indicators when assessing investor sentiment. This indicator boasts a key advantage over others in that its explanatory power is most significant over the long term. Unlike most sentiment indicators, which are limited to projecting trends over one to three months, the junk-bond spread provides insights into the one to three-year horizon.
Implications for Recession Risk
On one hand, this longer-term outlook provides some reassurance as it implies that a recession may not materialize in the next few months. On the other hand, this analysis also suggests that the risk of a recession will persist for the foreseeable future.
It is important to note that while this analysis raises the possibility of a recession, it does not guarantee its occurrence. However, it aligns with contrarian theory, which suggests that a recession may coincide with a market celebrating a soft landing.
The Stock Market’s ‘Bad Breadth’ Raises Concerns Among Bulls
By Mark Hulbert
The stock market’s recent performance has left even the most confident investors feeling uneasy. The phenomenon known as ‘bad breadth’ is causing concern among bulls who fear that it could be a warning sign of a larger downturn.
Assessing the Market’s Breadth
‘Breadth’ refers to the number of stocks participating in a market advance or decline. In a healthy market, a majority of stocks will be moving in the same direction. However, when breadth is poor, it means that only a select few stocks are leading the way while the majority are lagging behind.
Currently, the stock market is experiencing poor breadth, with only a small group of stocks fueling the recent rally. This has raised concerns among bullish investors who worry that the market’s gains may not be sustainable without broader participation.
Takeaways from January’s Rally
The impressive rally seen in January has many investors wondering about the sustainability of such gains. Historical data suggests that strong January performances are often followed by positive returns for the rest of the year. However, if the market’s breadth remains weak, this historical pattern may not hold true.
Investors should closely monitor the market’s breadth indicators to determine if further caution is warranted. While there is still optimism among bulls, it is important to acknowledge the potential risks posed by poor breadth. A more cautious approach may be necessary until a healthier level of participation is observed throughout the market.
Read here for insights on what to expect from stocks in February after January’s big rally.