Dump in junk bonds could trash stocks

It was barely a month ago that the only thing Wall Street worriers could find to complain about was the eerie market calm. Volatility was too low, they said, investors were content sitting on risky assets and the Standard & Poor’s 500 hadn’t had a one percent daily move in months. Fed Chair Janet Yellen was even moved to weigh in on investor overconfidence and under-pricing of risk in a few market segments.

Flash to now to find global markets in a slow-motion freak-out. German stocks have corrected by 10%, US small caps (^RUT) are almost there, the Japanese market (^N225) dumped by 3% overnight and the volatility index (^VIX) has popped from 11 to nearly 17 in 16 days. And in the past week alone American investors have yanked a record $7.1 billion from junk-bond funds – spurning, for the moment, one of their most beloved asset plays of the past few years.

The reason for this sudden collective loss of nerve, we are told, is that the world is too much with us. Russia and Ukraine, Israel and Hamas, the United States and ISIS, Africa and Ebola – lots of messiness in world affairs of the sort that financial markets have trouble processing and predicting.

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Without entirely dismissing the standard “geopolitical concerns” explanation for this retreat from risk, never forget that headlines are almost always excuses – and not reasons – for an investor response. This is all taking of place in the context of a sideways, churn year for stocks after they surged more than 30% in 2013, got somewhat pricey and became vulnerable to the waning of a few of the key assumed supports for risk assets:

The Fed, in a careful and utterly transparent way, is trying to back away from emergency-style policy, even as the housing market has cooled. European growth, meantime, is again flat-lining and the central bank there does not seem as willing as our Fed to write blank checks even as the Ukraine situation degenerates into a trade war. German 10-year government bonds have been bid so high in a rush for safety that they yield just a bit over 1%, telling you we’re back on deflation/recession watch in the Continent. This is shaking hot money out of riskier European debt, a trendy hedge-fund trade in recent months, and summons memories of earlier Euro crises of confidence. The corporate merger hustle had a reality check this week, with a couple of marquee deals scrapped.

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The support of overly generous credit markets – with the feast on junk bonds at the center – has been maybe the best thing stocks have had going for them. Make no mistake, those markets are still flush and money is still cheap there, with so-called high-yield bonds yielding less than 6% even after this recent purge. This market needs to settle down in order for stocks to put in a reliable bottom. It’s worth pointing out that retail investors, who are the ones fleeing junk now, are not known for their sharp market timing. And none of the skittishness here appears closely related to big concerns about the actual creditworthiness of issuers.