Dump in junk bonds could trash stocks

Yahoo Finance

It was barely a month ago that the only thing Wall Street worriers could find to complain about was the eerie market calm. Volatility was too low, they said, investors were content sitting on risky assets and the Standard & Poor’s 500 hadn’t had a one percent daily move in months. Fed Chair Janet Yellen was even moved to weigh in on investor overconfidence and under-pricing of risk in a few market segments.

Flash to now to find global markets in a slow-motion freak-out. German stocks have corrected by 10%, US small caps (^RUT) are almost there, the Japanese market (^N225) dumped by 3% overnight and the volatility index (^VIX) has popped from 11 to nearly 17 in 16 days. And in the past week alone American investors have yanked a record $7.1 billion from junk-bond funds – spurning, for the moment, one of their most beloved asset plays of the past few years.

The reason for this sudden collective loss of nerve, we are told, is that the world is too much with us. Russia and Ukraine, Israel and Hamas, the United States and ISIS, Africa and Ebola – lots of messiness in world affairs of the sort that financial markets have trouble processing and predicting.

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Without entirely dismissing the standard “geopolitical concerns” explanation for this retreat from risk, never forget that headlines are almost always excuses – and not reasons – for an investor response. This is all taking of place in the context of a sideways, churn year for stocks after they surged more than 30% in 2013, got somewhat pricey and became vulnerable to the waning of a few of the key assumed supports for risk assets:

The Fed, in a careful and utterly transparent way, is trying to back away from emergency-style policy, even as the housing market has cooled. European growth, meantime, is again flat-lining and the central bank there does not seem as willing as our Fed to write blank checks even as the Ukraine situation degenerates into a trade war. German 10-year government bonds have been bid so high in a rush for safety that they yield just a bit over 1%, telling you we’re back on deflation/recession watch in the Continent. This is shaking hot money out of riskier European debt, a trendy hedge-fund trade in recent months, and summons memories of earlier Euro crises of confidence. The corporate merger hustle had a reality check this week, with a couple of marquee deals scrapped.

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The support of overly generous credit markets – with the feast on junk bonds at the center – has been maybe the best thing stocks have had going for them. Make no mistake, those markets are still flush and money is still cheap there, with so-called high-yield bonds yielding less than 6% even after this recent purge. This market needs to settle down in order for stocks to put in a reliable bottom. It’s worth pointing out that retail investors, who are the ones fleeing junk now, are not known for their sharp market timing. And none of the skittishness here appears closely related to big concerns about the actual creditworthiness of issuers.

Let’s dial it back to a wide angle: The S&P 500 remains near the middle of its 2014 range, up a couple percent on the year and down 4% from its high. As all the global conflict noise has grown, corporate earnings have held up OK and forecasts are even rising a bit for next quarter.

This is the way value is rebuilt in markets – painfully, through confusing and treacherous price declines that are not mainly prompted by corporate fundamental changes. When stock prices drop while profits hold up, stocks become less risky, not more. When financial markets start cooling, Janet Yellen is pleased not to have to use interest-rate policy as a rude cold shower. Long-term investors should be hoping that stocks fall even more if the reasons are general unpleasantness and intermittent skirmishes across the globe.

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Of course we could be in for more nastiness – volatility cycles don’t run their course in three or four weeks, typically. This is the 100th anniversary of the start of World War I, so the capacity for human folly and political contagion shouldn’t be dismissed.

And this is a mature bull market – one that was approaching an “overshoot phase” on the upside as recently as late July. Another 5% drop from here wouldn’t even get the indexes to their early-February low.

But not much has happened - yet - to suggest that the world’s capacity for unnerving drama will upend the broad trend of slow-but-positive economic growth and corporate prosperity.

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