There is an old investment adage that says the bond market is a lot smarter than the stock market.  What they mean by that is bonds tend to lead and stock follow. As such, wise stock investors know it pays to watch what the bond market is doing.

 What I like to do is watch for changes in the bond market investor’s risk appetite. It makes sense to me that if bond investors in are allocating the bulk of their money into the highest risk bonds (“junk”) as compared to the least risky (US treasuries) you can reasonably assume safety is not their main concern (“risk-on”). In this risk-on environment, it follows that stock investors are also more comfortable with over-exposure to the stock market. If the converse is true and bond investors are more risk averse (“risk off”) and shifting their money into US treasuries, stock investors should pay attention and consider appropriate action.

 The chart below, a ratio of high yield bonds (riskiest) to US treasuries (least risky), provides a historical snapshot of bond investors risk willingness over time. As you would expect values of this ratio move up and down but like all investments but it’s when values are at extremes there is reason for action. As you can see we went into January of this year at the 2nd highest level seen in the past 10 years.  Just as importantly since the start of the year, we have formed a topping pattern and have since begun to break down. I want to draw your attention to one last fact which is there have been 3 times in the past when this ratio was overbought and created a divergent high and I have noted those times with the dotted red vertical lines. What is important about these points is that each time it has occurred stocks (see lower pane of SP500 price) followed with a double digit decline. The 2008 correction was a ~56% waterfall, the 2010 correction a ~16% drop and finally the last time it occurred in 2011 stocks declined ~18%.

 You can see we have this same set up right now, today.

It may be a bit too early to tell but what’s the odds the smart bond market is wrong this time?