After a brief equity weakness during the last week of January, major stock market indices recouped all their losses and currently are at or near record levels, states Joon Choi of Signal Alert Asset Management.

Investors continue to add equity exposure as 2020 4th quarter corporate earnings are coming in better than analysts estimated. In fact, with percentage of earnings beating concensus’ estimates, it is on track to be at its second highest level (81%) since FactSet started tracking this metric in 2008. In this article, I will discuss why high-yield bonds may offer a better upside potential in the coming months if stocks continue to outperform the risky bonds.

High-Yield Bond Index

Merrill Lynch (bought by Bank of America during the financial crisis) started tracking high-yield bonds in 1997 and this index is commonly used as a benchmark (MLHY). Bank of America also publishes an effective yield for the aforementioned high-yield bond index which currently stands at 4.15%; a record-low reading (Chart 1).

mlhy

spy vs. bank

The Study

Since the Federal Reserve Bank cut the overnight lending rate to essentially 0% in December 2008 to combat the financial crisis, SPY gained 15.1% a year versus 10.8% for MLHY (Chart 2).

spy/mlhy

To determine their relative strength (RS) I divided SPY by MLHY which is displayed in Chart 3. In addition, I calculated and plotted their 20-month exponential moving average of SPY/MLHY which has been in an uptrend since 2013.

difference

Then, I took the difference between the SPY/MLHY ratio and its moving average (Chart 4). After RS penetrated above 11% in December 2013, it has been oscillating between 0% and 11%. It exceeded 11% again four more times; with the last occurrence being the current month (albeit we still have 3 more weeks to end of month).

After reaching the 11%-mark, SPY returned an average of 0.2% (Points A thru D in chart 4 and table 1) during the ensuing 3 months; whereas, MLHY gained 2% (outperforming SPY on 3 out of 4 occasions).

performance

Interestingly, SPY had very strong outperformances after the RS fell below 0 on three occasions (points X, Y, & Z in chart 4 and table 2). It saw an average of 13.8% three months after its breakdown below 0 which is more than twice as much as MLHY (6.6%).

summary

Conclusion

Although the stock market has been strong in recent months, the gap between SPY/MLHY and its 20-month moving average suggests that SPY’s relative strength may be over-extended and high-yield bonds may outperform SPY in the coming months (if SPY/MLHY’s ratio does not deteriorate from its current level by month end). I believe an upward thrust of SPY will wane in the coming months as equity valuations appear to be fully pricing in investors’ optimism. Therefore, I recommend adding to high-yield bonds instead of SPY, at least for next few months.

To learn more about Joon Choi, please visit Signal Alert Asset Management.