Stocks have been defying gravity recently. They were moving relentlessly higher. But then last week, they hit a tax-reform speed bump.
The Dow Jones Industrial Average snapped an eight-week winning streak last week, falling half a percent. Meanwhile, the Dow Transportation Average dropped 2.6%, continuing a bearish non-conformation with the Industrials.
The primary reason for the pause seems to be tax-reform trouble in Congress. The differences between the House and Senate versions of the legislation are proving more difficult to reconcile than expected.
Markets are nervous that we won’t see corporate tax reform in 2017. But forget about Congress pushing it out to 2018 — many are starting to think we might not see tax cuts until 2019!
Related story: Tax Reform: Be Careful What You Wish For
But another indicator has been sending up a major red flag for weeks now: high-yield corporate bonds.
And that’s making stock investors increasingly nervous …
The chart above shows the SPDR Barclays High Yield Bond ETF (JNK), which tracks a widely followed index of junk bonds. You can clearly see that junk bonds peaked back in August. Then a half-hearted rally attempt in September and early October fell short of notching a new high.
Junk bonds rolled over and began plunging lower last week, before bouncing a bit on Friday. But it looks like the damage is done.
High-yield bonds are clearly in a downtrend … and likely headed a lot lower.
So why is that potentially bad news for stocks?
Typically, junk bonds trade more in line with stocks than with Treasury bonds. They often serve as a leading indicator for where stocks will head next.
The last prolonged slump in junk bond prices happened in late 2015. JNK plunged more than 20% going into early 2016.
Stocks initially held up OK. But they finally came unglued, with the S&P 500 Index falling 14% from November 2015 until stocks bottomed in February 2016.
That’s why the divergence — between the Dow hitting new record highs while high-yield bond prices tumble — is a big red flag in my book. And it warns of potential trouble ahead for stocks.