The Dow dropped into negative territory for the year last week, down more than 500 points from the high set on Monday. The index is back below its 200-day moving average, a key measure of technical strength.
With the relief over the Greek debt deal two weeks ago fully faded — replaced by a nervous acknowledgement a resolution for Athens hasn't been achieved but only further delayed — investors have grown preoccupied with the flow of disappointing Q2 earnings results from some of the largest and best known publicly traded companies, though there have been some blowouts mixed in.
Also weighing on sentiment has been the ongoing rout in industrial commodities and high-yield or "junk" bonds.
West Texas Intermediate crude oil is back down to $48.11 as the impact of growing inventories and the Iranian nuclear deal keep reverberating. Shale companies are being forced into cash conservation mode, with Chesapeake Energy (CHK) recently suspending its dividend. The JP Morgan Alerian exchange traded note (AMJ), a dividend-focused fund tracking the performance of energy-sector master limited partnerships, sits at the nexus of the energy price/high-yield bond price declines and is down nearly a third from its high last summer.
In a recent note to clients, Morgan Stanley warned that on the current trajectory, the oil price slump could become worse than what was suffered in 1986. Commodity analyst Adam Longson sees the oil market as currently oversupplied by about 800,000 barrels per day. Unless OPEC cuts output soon we could be on the cusp of the worst crude selloff in 45 years or more, with all the accompanying negative effects on S&P 500 earnings growth.
The chart below of the iShares High Yield Corporate Bond Fund (HYG) reveals the turmoil underway in the riskier parts of the fixed income market. The fund has dropped to levels last seen in January.
Stocks just can't be bothered, though: The S&P 500 is less than 2 percent from its record high. According to Jason Goepfert at SentimenTrader, the only time over the last 30 years that stocks have shrugged off a selloff in high yield bonds to this extent was in 1999-2000. Back then, the S&P 500 dropped 13 percent over the next several months, but the dot-com bubble didn't actually end for another year.
But the shifts in the high-yield market are a big sea change with consequences that could still ripple into other asset classes, including equities.
Alberto Gallo, head of macro credit research at RBS, notes that U.S. high-yield debt became a symbol of the recovery fueled by the emergency stimulus from major central banks following the financial crisis. The asset class generated an annualized total return of 9 percent between 2010 and 2014, outperforming the stock market in three of the five years. But the worm has turned, with high-yield bonds underperforming badly following the positive 11th-hour outcome in Greece.
Gallo fingers four causes for the junk bond pullback.
The first is mounting fear over the approach of interest rate “liftoff” from the Federal Reserve.
The second is concern over rapid fund outflows — in the context of low liquidity in many areas of the bond market — should the Fed's tightening campaign result in selling. Outflows from junk bonds totaled nearly $13 billion after Fed Chair Janet Yellen said the high-yield bond market was overvalued.
The third is heavy new supply as year-to-date high-yield issuance is more than 30 percent higher than the same period last year.
And finally, credit fundamentals have started to deteriorate with leverage measures on the rise and default rates increasing. Gallo is forecasting an increase in default rates to 4 percent by the end of the year vs. 2 percent at the end of June.
The takeaway is that both high yield and commodities are under increasing pressure — something that stocks will be hard pressed to ignore. Already, we’ve seen a collapse in stock market breadth. Fewer and fewer stocks remain above their 50-day moving averages, raising a nagging feeling that the Dow has much further to fall, perhaps into a 10 percent-plus correction of the type not seen since 2012.