JNK - Move Over Small-Cap Stocks. The Great Rotation Into Bonds Is Coming Next.

2023-07-17 13:14:08 ET

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We often hear about a rotation from large-cap stocks to small-cap stocks on widening breadth that can carry the bull market’s next leg. I don’t disagree with this fundamentally, but it’s a question of timing. Small-cap stocks relative to large-caps are treading water, back to levels not seen since the depth of the Covid-19 crash despite a “strong” economy.

Yes, FOMO is more powerful than the Federal Reserve, but only to a point. I worry that just as everyone capitulates on the recession narrative, a recession then comes sooner than most expect. I’ve argued for some time that this was a melt-up year given pre-election dynamics, but that a “credit event” is likely out there to end the bear market I believe we are still in (a bizarre idea I know).

The Great Rotation refers to a significant shift in investment strategy where investors swap out of one asset class into another, primarily motivated by changes in the economic environment. The term is often used to describe rotating into equities from bonds. But what if we are on the precipice of a rotation the other way around – from stocks back to bonds?

A Great Rotation Into Bonds, Not Small-Cap Stocks

Take a look at the price ratio of the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT ) relative to the S&P 500 . Clearly stocks have meaningfully outperformed equities over the long run, but those spikes you see that seemingly come out of nowhere coincide with CBOE Volatility Index (VIX) spikes and risk-off periods.

Given what looks like capitulation in Treasuries relative to equities, and optimism as high as it is for the stock market, I wonder if we are about to see a move back into Treasuries.

Note that I’m talking about this from a trading perspective, but from an investment perspective, we could still see stickier money flow into high-quality bonds. Why am I making the distinction with high quality? Because there’s likely a lot of risk in junk debt, as tracked by the SPDR Bloomberg High Yield Bond ETF (NYSEARCA: JNK ), from a buy-and-hold perspective. In recessions, the differential between high-yield bonds and AAA paper widens as credit spreads increase.

Junk Debt relative to nominal Treasuries are back at levels not seen since April of 2022.

From April-June of last year, the S&P 500 then fell 15%.

I'm normally not a fan of these comparisons, but the mispricing of risk in the bond market should give you pause. pic.twitter.com/oMXNXk3Ri7

— Michael A. Gayed, CFA (@leadlagreport) July 17, 2023

Last year, the flight to safety trade badly failed, what I called my “hell” repeatedly on Twitter ( @leadlagreport ). But if the duration crisis manifests into a full-blown credit crisis, I suspect the historical behavior of long-duration Treasuries will resurface. This will push stocks lower with investors flocking to AAA bonds not only to capture yield, but to have comparative. The timing seems interesting here, given the very real possibility that the Fed not only hikes rates again, but also contrarianism with seemingly no one wanting to sell their stocks to buy boring bonds.

This remains a challenging environment. My risk signals noted in The Lead-Lag Report are beginning to show signs of flipping from risk-on to a risk-off stance, suggesting higher volatility may be just around the corner. If I’m right, the Great Rotation isn’t into small-caps – it’s into fixed income again.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines .

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