Another first time signal was given in 1995, but the real warning wouldn’t come until mid-1998. Notice that this was 18 months prior to the market peak. The next bear market warning would come in late 2007, but on this occasion the lead time was very minimal. The fact that this indicator leads is unquestioned, but investors should be aware that the window can vary by up to twelve months. This is why an objectionable investment plan is required to ensure one stays the course amid the bull and bear prognostications.
So where are we today? We have already had the first “scare” in 2011 that washed out sentiment and set the stage for major indices to reach new all-time highs this year. The chart below shows the 1-year total return for high-yield bonds is currently at +12% and well clear of any danger signs. When this falls to +2%, it will indicate a big red flag for U.S. equities.
HYG Total Return Price data by YCharts
Stocks to Avoid
Given that we are approaching the later innings in this cyclical rally, individual equity decisions should reflect this outlook. Material stocks have been crushed lately, but I would stay clear of the entire space until after the next bear market. It would probably be prudent to again ignore Barron’s recent recommendation on Cliffs Natural Resources Inc (NYSE:CLF). The iron-ore miner has seen its stock routed to the tune of 70% over the last year as high fixed costs and collapsing iron-ore spot prices weigh down earnings. The stock is cheap, but fundamentals are deteriorating and it is a classic value trap. There may be long-term upside, but there is also plenty of near-term downside risk as well. Remember, buy and hold is not the key to beating the market. It is better to wait for improving fundamentals and own Cliffs Natural Resources Inc (NYSE:CLF)’s after the next bear market, not before.
The same thing goes for the iron-ore leader Vale SA (ADR) (NYSE:VALE). The low cost world leader in iron-ore mining won’t exhibit the same earnings volatility as Cliffs Natural Resources Inc (NYSE:CLF), but is still subject to earning a profit by being a price taker. The high trailing dividend yield above 5% is artificial given the irregularity of payments. The company did approve $4 billion in minimum distributions which equates to a yield above 4%. But don’t be fooled by the dividend yield, the company faces weak earnings prospects and enormous stock downside during bear markets.
The Foolish Bottom Line
I have highlighted the importance of following high-yield bonds in gauging the prospects for the U.S. equity market. It is one of three simple tools the average investor can use to generate a long track record of market-beating performance. Right now it is clearly indicating more upside in this mature bull market. Stay the course with equities, but be cautious on risky sectors such as materials that are prone to big drawdowns during bear markets. The next blog will highlight another tried and true indicator that is also supportive of continued equity upside–the yield curve.
Justin Carley has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
Related ticker: Cliffs Natural Resources Inc (NYSE:CLF)
