The Downside Potential According to Stocks and Bonds

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You might ask yourself: "what do these two asset classes have in common?" The answer is fairly simple; The semiconductors, as I often say, are the engine that drives the modern, tech-driven economy. When things like geopolitical uncertainties are perceived as a threat, investors generally flee the riskiest of assets and seek shelter in safer investments like bonds. As a result, stocks fall, chief among them are the techs, and particularly the semis that are at the heart of just about everything. 

Conventional wisdom says that as stock prices fall, bond prices rise due to the increased demand for safer investment instruments. As a result, bond yields fall. But in recent years, the correlation between stock and bond prices has clearly bucked conventional wisdom. 

In the first chart below, the semis ($SOX) are shown to have already broken down, and technically speaking, they have their sights set on a much lower target. As for bonds, the second chart depicts the price behavior of $SHYG (iShares 0-5 Year High Yield Corporate Bond ETF) during calm and turbulent times. And last but not least, the third chart depicts the behavior of the S&P 500 at and around the same junctures indicated on the chart of $SHYG. 

(Click on a chart to enlarge it. Hold down the left mouse button to move around it. Press ESC to close it.)


In June 2014, $SHYG embarked on a downward phase that wouldn't end until February 2016. As for $SPX,  it continued to advance, albeit laboriously, until it finally topped in May 2015, almost a year later. But this advance certainly wasn't devoid of the increased volatility that manifested itself in the form of a 10 percent pullback in stocks during the September-October 2014 period. From a wave theory standpoint, the advance that began back in October 2011 culminated in a terminal diagonal (they don't call it "terminal" for no reason). As for the ensuing correction, it unfolded as that blue zigzag which in turn set the stage for another momentous bull run.

Now fast forward to 2017-2018 and notice how $SHYG already topped over a year ago, in May 2017 to be exact, while stocks continued to march higher despite the steadily rising interest rates. But rising interest rates alone aren't enough to derail stocks if the indicators continue to point to an expanding economy. However, there's enough turmoil nowadays in Washington, DC and the rest of the world to justify a flight-to-safety move on the part of investors. From a chart pattern standpoint, notice the lower high registered in September 2018 compared to the May 2017 high, and then contrast that with the multitude of higher highs in the stock market throughout this same period. At some point, these notable divergences will have to manifest themselves before equilibrium is finally restored. 

The chart of $SHYG clearly sports a Head-and-Shoulders pattern, albeit unconfirmed. It will remain so until the February low is taken out at some point. If and when this occurs, the measured move indicates a downside target in line with the rejection zone established by the candlestick shadows (or wicks) of January and February 2016. 

In summary, technical analysis is a visual endeavor highly reliant on the power of observation and one's ability to stitch the pieces together to form a holistic picture. Should this technical thesis be proven right, $SOX and $SHYG (or pick another bond-related ETF such as $SJNK) should serve as "market timers" signaling the end of the correction and the start of yet another bull run. 

Trade vigilantly,

Peter Ghostine (@peterghostine)

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