Near-perfect sell signal says stocks should drop

Trader on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Trader on the floor of the New York Stock Exchange.

It's the No. 1 question puzzling traders right now: How can prices for high-yield bonds be falling and prices for stocks rising, when they've so reliably traded in tandem in the past?

Prices for high-yield bonds are a great coincident—and sometimes leading—indicator for stocks because they are just above equities on the risk scale. When investors feel less comfortable about the world, they cut junk bonds from their portfolio first and then stocks second.

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High Yield ETF (HYG) vs S&P 500

Source: FactSet

One glance at the chart shows that something is off. The S&P 500 and the iShares iBoxx High Yield Corporate Bond ETF are a mirror image since the start of the year, but since the end of October, high yield has diverged to the lower right, and yet the S&P 500 has continued to record highs. Since separating in October, the S&P 500 is up 3 percent, while the high-yield ETF is down 4 percent.

On 10 occasions since 2007, the high-yield ETF dropped 5 percent in 30 trading days. During nine of those instances, the S&P 500 fell as well, with an average return of negative 9 percent, according to CNBC analysis using Kensho.

Only once did high yield give a false sell signal. That was last year, when the market was already entranced by the Federal Reserve's quantitative easing program, which has seemed to elevate stocks with an abnormal consistency. And even then, the S&P 500 managed just a 0.4 percent climb amid the junk debt rout.

The individual securities most sensitive to a fall in high-yield corporate bonds (and subsequent rise in their yields) are not behaving this time either.

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General Growth Properties and Kimco Realty are real estate investment trusts that thrive when low interest rates allow even the riskiest borrowers to get loans and pay their rent. The REITs, which sport large dividends, also benefit when bond yields are low, as the debt market offers little in competition to their high-paying shares then in the eyes of investors.

When high-yield prices fell, General Growth and Kimco shares dropped 100 percent of the time, posting average returns of negative 30 percent and 20 percent, respectively, according to Kensho.

Yet General Growth and Kimco hit new highs for the year this week.

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To be sure, the pullback in high yield could be due solely to just the energy-related part of the debt market as the extreme drop in crude prices makes it harder for them to pay their bills. Energy stocks have been hit hard over the last month, yet the S&P 500 continues higher.

But if this is just an isolated incident in one sector of the high-yield debt market causing the drop, it would be the first time that's happened without affecting stocks in the last eight years.

—CNBC's parent NBCUniversal is a minority investor in Kensho.

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