At a conference in Chicago last week, following up on a recent On My Radar, Keep Dancing but with a Sharp Eye on the Tea Leaves, an advisor client asked me what my favorite “tea leaf” might be. When one of the greatest investors of our time, Ray Dalio, tells us to keep an eye on the exit door we should take note. But how? And when? There is no perfect indicator, but there are a few very good ones and it’s been my experience that simple is best and trend following works well.
Since we were talking about the economy and the stock market and since all the bad stuff in the stock market happens during recessions, my answer was to watch the trend in the high yield bond market. The players have a keen eye toward the economy and potential default risks in the bonds they own. Thus, in my view, high yield tends to be a pretty good “tea leaf.”
Watching the trends every day since the early 1990s has taught me that the high yield market generally leads the equity market by six months or so. It’s not exact, but in my 25 years of trading high yield, it’s been my observation (with real money on the line) that high yield is sensitive to the economy and tends to lead equities lower. I believe it is because high yield bond managers are razor-focused on changes in their underlying bond credits (default risks) and react just a bit faster than equity investors. More sellers than buyers drive prices lower.
So how can you keep your eye on this? Following is a weekly chart of the PIMCO High Yield Fund going back 19 years to 1998. The chart shows weekly price data. The orange line is a simple 13-week smoothed moving average price trend line. When the current price drops below the smoothed trend line, a sell signal is triggered.
I remember taking a lot of heat from clients in 1999. High yield rolled over in 1998 while the tech bubble bubbled on. Then it broke. Avoided were the recessions in 1991, 2000-02 and 2008-09.
Here is the chart and how to read it:
- The data is weekly price data for the PIMCO High Yield Fund (PHIYX).
- The orange line is the 13-week moving average line. Think of it as a smoothed moving average of the trend in price over the preceding 13 weeks.
- When the price drops below its trend line, that’s a warning signal (red arrows).
- When the price moves above the trend line, it is a buy signal (green arrows).
- Note – arrows show only a few of the signals to give you a sense of how it works. More attention should be paid late in a business cycle (like today).
It’s important for me to say that we use a trend following process that triggers more quickly than the above for our high yield trading, but the point is that trend following can help you gauge turning points in the economy and the stock market. High yield is a leading indicator for both the economy and for equities. Experience has taught me it is a tea leaf worth watching. Of course, past performance does not predict, indicate or guarantee future results.