Many investors think of the stock markets as a giant cash register. Just put your shares in and take cash out. However, there is not an endless supply of cash in the markets.

Someone must be on the other side of the cash register putting money in so you can take it out. That is called liquidity, and it is the mother’s milk of stock markets. When there is not enough cash to balance the needs of buyers and sellers, that spells trouble for the financial markets. We call this illiquidity.

My friend and newsletter writer, Tom McClellan, uses the phrase “canary in the coal mine” to describe the ability of high yield (junk) bonds to forecast upcoming stock market declines. Canaries are much more sensitive to poisonous gasses than are humans, so canaries were carried into mines by coal miners as an early warning system. If the canary stopped singing and fell off its perch, it warned miners that the air was becoming worse in time for them to get out.

Junk bonds are our canaries.

Since illiquidity is the root cause of all market declines, Ryan and I track money flows into and out of the markets. Junk bonds, just like the canaries in coal mines, can tell us when liquidity is falling, and it may be a good time to lower our exposure to market risk.

Most of the time, the junk bond market goes in the same direction as the S&P 500. But when junk bond prices diverge from the S&P 500’s direction, it gives us great insights that the stock market is likely to be changing, so pay attention. This means if the stock market has been strong and we get a “sell signal” from our illiquidity gauges, a decline is very likely.

Government intervention can inject liquidity into the markets, and some illiquidity events are news-driven and quickly dissipate, so not all junk bond illiquidity signals lead to stock market declines. However,  significant stock market declines are preceded by these signals, so they are one of our best predictors of when to reduce risk. Since market declines start out small and one can’t usually see any difference between small and large declines in their early stages, we respect each set of sell signals.

Despite the occasional head-fake, these money flow signals are our canary in the coal mine, and right now, the canary has croaked!   Money flow signals tell us that the potential for a continued decline in the stock markets is significant, so we are being proactive on your behalf (assuming you are already a client). We have moved client accounts to a much more conservative investment position, and you will find that the majority of your investments are already out of the stock markets at the moment.

If you are not yet a Shadowridge client, call the office at 888-434-1427 to schedule a quick portfolio review and determine if our proactive investment management can help you invest more successfully. Please call before a significant stock market decline, rather than after when it may be too late.


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