High yield bonds just fired a warning shot.

The action in the junk bond market tells us a lot about the average investor’s willingness to take risk. That, in turn, tells us about the potential for a rise or fall in the stock market.

When high yield bonds are rallying, it’s a “risk-on” environment. That tends to be bullish for stock prices.

When high yield bonds are falling, investors are in a “risk-off” mode. That’s bearish.

For the past six weeks, the junk bond market has been stuck in a tight trading range, which is neither risk-on, nor risk-off.

Not surprisingly, the broad stock market has also been stuck in a tight trading range. The S&P 500 started the month of April at 4122. It’s right near that same level today.

But, the high yield bond market broke down on Tuesday. If it doesn’t recover right away, then the stock market is in for a tough time.

Look at this chart of the iShares iBoxx High Yield Corporate Bond Fund (HYG)…

On Tuesday, HYG closed below the support line of its six-week-long consolidation pattern. If it doesn’t recover and close back inside the pattern within the next day or two, then HYG is most likely headed lower.

The next support level for HYG is down at the March low at about $72.50 per share. That would paint a rather ugly picture on this chart.

The action in HYG tends to lead the action in the stock market by anywhere from two days to two weeks. So, if HYG continues lower – towards its March low – then the stock market is vulnerable to a decline towards its March low as well.

That implies a drop towards 3850 on the S&P 500. That’s more than 6% below the current level.

Maybe that seems extreme to some readers. But, keep in mind…

The last time HYG fired a warning shot was back on January 31. The S&P 500 was trading near 4050 at the time, and we warned the stock market was headed for trouble.

Six weeks later the S&P was at 3850.

Best regards and good trading,

Jeff Clark

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Source: Jeff Clark Trader