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Questioning Junks

01/17/13 by  
Filed under Bourbon & Bayonets

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We now move from the bizarre to the mAcAbRE.

As the global financial reality moves into unprecedented territory, raised higher by an intervention never before known on these shores (if ever), and that has impinged on the free workings of the market mechanism to a degree never before countenanced by the American people, we find ourselves wide-eyed, agape and dumbstruck – and not a little spellbound – by the spectacle taking shape before our eyes.

To begin, we see a market whose earnings have been unimpressive of late coupled with a general rise in stock prices.  This has occurred solely due to what the brokerage industry refers to as ‘multiple expansion’, that clever sleight of financial hand that says,

“Yesterday, ABC stock was selling for ten times last year’s earnings, but today it will sell for fifteen times those same earnings even though nothing material has changed in ABC’s sales outlook or balance sheet. 

Why?  

Why, because we can!”

Miraculous.

What has changed – and what everyone realizes by now is truly catalyzing this rising market – is the underlying tide of liquidity in the system that’s now beginning its inexorable swell into equities.

This is a process that we’ve discussed at length since the very depths of the market’s decline in late 2008, when it became clear that something truly outrageous and ‘bold’ was about to transpire at the hand of the U.S. Federal Reserve.

And since then it has been bull steam ahead, as we suggested, with the ensuing rise punctuated only by an odd pullback to add flavor.

Now we appear ready for the next ‘lift’ – one that we believe will be among the strongest and fastest moves in market history.

Take a look at the chart:

The S&P 500 is now straddling overhead resistance at 1473 (black line) and whether it breaks above that level today or continues to bang its head unsuccessfully against it, will affect the action of the index for the coming weeks dramatically.

Our take is like this.

If we ascend above resistance, we expect to have a wild burst higher and a subsequent selloff that retests the 1473 level.  If, however, we fail here, the index could pull back significantly – even drop to the 1250-1300 area before regrouping and making another run at 1500.

The next few days will tell.

The fact that we have super-waterline action from both RSI and MACD indicators (in blue) leads us to tend toward the bullish scenario – a breakout and subsequent retest of support.  There’s also little in the action of the moving averages that would discredit that notion; they’re unfurled bullishly and trending higher in an orderly manner.

No fear, however; either way, we’ll be soaring stratospherically before very long.

What about our money, Matt?  Our money?  Remember?!

Yes, yes, my dear ones, to be sure.  As to where we should be allocating funds at this juncture, we say that times like these call for both caution and neck-on-the-line risk-taking – all at once!

That’s right.  We believe it’s possible to grab the best of both worlds and purchase a stock with a record of safety, a fat yield and great potential for further upside

And just what kind of stock would that be, you ask?

Well, well… isn’t it perfectly clear?

Look here:

High yield bond ETFs (like HYG, shown in the above chart) are tremendous bets.  Not only because they accomplish the entire foregoing – high yield, additional capital gains potential and relative safety, but also because they’re hot.

White hot.

The sector has had a tremendous and growing bid for well over two years and now looks ready to explode even higher (see volume – green line).

HYG has broken to new highs twice in the last five months, and all technical indications point to a continuation of the bull.

But spreads are so tight.  Isn’t now the time to sell?

Very true.  Our junk strategy of ‘buy wide and sell tight’ is still operative.  Junk is now trading at a very tight spread to Treasuries, just 5% over (longer term average is above 6%), and the only question now is whether it will tighten further still.

We believe it will.

Above is the B of A/Merrill Lynch Junk Index, showing the spread of a basket of high yielding bonds above Treasuries.  Clearly, the move this year was steep.

Last calendar year (2012) saw record inflows into the group, and it has now been four full years of positive returns for junk, leading some to suggest that the jig is up.

We say no.

Both Fitch and JP Morgan agree, predicting record low default rates from junk (2%) in 2013, while others (Morningstar) believe a backup in rates from treasuries and investment grade corporates will draw interest away from the asset class.

And while that’s possible, we don’t believe it will have a marked affect on stocks like HYG, COY and JNK going forward.

Why?

What’s often omitted from the junk bond calculus is that they trade off their underlying equities.  And with an equity market going jiggly-gang-boom, the above named junk ETFs will offer great upside, a great ‘coupon’ and all the momentum of a stock market that’s turbo-driven.

So what’s your question?

 

Many happy returns,

Matt McAbby, Senior Analyst, Oakshire Financial

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Comments

2 Comments on "Questioning Junks"

  1. Joel on Thu, 17th Jan 2013 4:16 PM 

    I’m in

  2. steve lincoln on Sat, 19th Jan 2013 4:48 PM 

    How about some advice on the ways and wisdom of leveraging a position in junk?


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