JNK Part 2

Linkable Real-time chart

It is not often I get to pat myself on the back, so I will take that rare opportunity now. The JNK and S&P 500 call in early April turned out to be spot on. The reason I bring it up is because right now it seems the disconnect is occurring again, except in the opposite direction.

Currently the S&P 500 looks extremely oversold compared to the JNK index. This is in contrast to early April where JNK was leading the markets lower. Today it seems JNK may be leading the markets higher. Please see the previous post on April 2nd for more information on the history of the two indices. JNK Part 1

The way to trade this is through a pairs trade. A pairs trade is similar to a hedge in which you initiate a long position as well as a short position with the hope of them converging. The beauty of a pairs trade is that it often lowers risk (since you are both long and short similar markets) as each entity acts a natural hedge of the other purchase.

Looking at the busy chart below, one can see the relationship between JNK and SPY in the middle graph.  It may be easiest to right click chart-->and open in a new tab to zoom in.  Most recently the disconnect between the two etfs is pretty apparent and what I am seeing as a potentially good pairs trade.  This is shown by the circles in the middle of the chart.  Also notice the 50 day correlations, usually hovering around 100 (other circles on the chart).  Today it seems that the junk bond market is not confirming the recent stock market weakness and can be viewed as being near term bullish stocks and/or bearish junk bonds.

In order to long the S&P500 and short the JNK, two etfs are readily available, the SPY (S&P 500) and the SJB (short junk bond). If one were to purchase both of these, an expectation of the stock market to rise and the Junk bond index to fall would occur. By purchasing these two etfs together one may be able to take advantage of the expected convergence and re-emergence of the high correlation of the two indices.  Once the convergence occurs a closing of both positions would lock in the trades and hopefully profits!  The risk is that the decoupling will now be permanent, and things indeed have changed, however, if thought rationally about the relationship between stocks and high yield debt, the debt prices should fall as equity prices fall and rise as equity prices rise as they both represent the same underlying companies.

Good Luck!