One of the world’s most important markets continues to flash danger signs…

Regular readers know we keep close tabs on the bond market. The bond market is where individuals, companies, and governments go to borrow money. The U.S. bond market is about twice as large as the U.S. stock market. That’s one reason the bond market can signal trouble before the stock market.

•  The junk bond market is where companies with shaky finances borrow money…

Junk bonds are riskier than bonds issued by healthy companies, so they pay higher yields.

When the economy slows, companies in bad financial shape often feel it first. That’s why economic trouble tends to show up in the junk bond market early on.

•  Junks bonds are set to have their first down year since the financial crisis…

On Monday, The Wall Street Journal reported that U.S. junk bonds are down 2% on the year. If they end the year down, it would be their first losing year since 2008.

•  Bond defaults are at their highest level since 2009…

Worldwide, companies have already defaulted on $95 billion in debt this year. That translates to 102 corporate defaults, or 42 more than last year. U.S. companies account for over half of these defaults.

•  Moreover, the U.S. energy sector accounts for 26% of global defaults this year…

Casey readers know the U.S. energy market is struggling…

Yesterday, the price of oil hit a new six-year low. It’s plunged 66% since last June. And the price of natural gas has plunged 56% since last summer.

Most oil and gas companies’ profits have plummeted. As a result, companies that borrowed big before energy prices crashed are struggling to pay back their loans.

•  Credit rating agency Standard & Poor’s says half of all energy junk bonds are distressed…

A distressed bond has a high risk of default. And the trouble isn’t isolated to energy bonds. Last week, Bloomberg Business reported that 20% of all U.S. junk bonds are now distressed. That’s the highest level since September 2009.

•  Corporate defaults could double in 2016…

So far, only 2.6% of junk bonds have defaulted this year. However, that figure will likely jump soon.

On Monday, The Wall Street Journal reported that defaults are expected to nearly double to 4.6% next year. If that happens, junk bonds would pass their 30-year average default rate of 3.8%. That also hasn’t happened since 2009.

•  Meanwhile, the U.S. stock market is showing big cracks…

Last week, we explained how a handful of huge companies are making the U.S. stock market look healthier than it really is. This includes Google (GOOG), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Netflix (NFLX).

When most investors talk about “the stock market,” they’re talking about the popular S&P 500 index. The S&P 500 is weighted by company size, which means bigger companies affect its performance far more than smaller companies.

For example, Google is the second-largest company in the S&P 500. It’s up 43% on the year. Amazon is the sixth-largest company. It’s up 113%. Facebook is the eighth-largest. It’s up 35%.

Meanwhile, S&P 500 stocks are trading 18% below their 52-week highs, on average.

•  This chart shows what’s really happening in the stock market…

It’s one of the most important charts in the world right now…

It compares the S&P 500 with a version of the S&P that gives equal weight to every company. In the equally weighted S&P, toymaker Hasbro (HAS) has as much weight as Google, which is 61 times bigger than Hasbro.

These two indices tracked each other for most of 2015. However, in recent weeks the S&P 500 has pulled ahead of the equally weighted S&P, which is now down 4% on the year.

This is a big red flag. It’s confirmation that a few big companies are holding up the stock market.

•  The U.S. stock market flashed the same red flag in 1999…

A handful of big stocks pulled the major indices higher that year, while most U.S. stocks struggled. By 2000, the S&P 500 turned down and went on to lose 48% in 32 months. The NASDAQ crashed 78% in the same time.

The U.S. stock market is like a healthy-looking tree that’s actually rotting on the inside. Eventually, when the largest stocks can’t prop it up anymore, the entire tree is going to fall.

•  We recommend investing with extreme caution right now…

You should hold a significant amount of cash and some physical gold.

You may also want to hedge your portfolio by shorting (betting against) stocks likely to crash hard during the next big downturn. This could mean shorting very expensive stocks. It could also mean shorting businesses that will struggle to make money during a prolonged economic slowdown.

We recently recorded a video presentation on the topic of investing during difficult times. Doug Casey, founder of Casey Research, gave his advice on how to protect your money and make more money during a major market collapse. Click here to watch – it’s free.

Chart of the Day

Here’s another clue U.S. stocks are topping out…

Professional investors often look at “spreads” to gauge the market’s strength. A spread is the difference between two prices or interest rates.

One important spread subtracts the interest rate paid by junk bonds from the interest rate paid by U.S. Treasuries. U.S. Treasuries are bonds issued by the U.S. government, which is widely considered one of the safest borrowers in the world. Junk bonds, on the other hand, are issued by riskier borrowers.

Today, the interest rate on Treasuries is 2.1% and the average interest rate on junk bonds is 8.8%. So the “spread” is 6.7%.

When the economy is humming along, this spread typically gets smaller. Companies generally make good on their bonds during good economic times, so investors don’t demand a big interest rate premium.

However, when the spread starts to get bigger, it’s a sign of trouble ahead for the stock market. For example, this spread started to get bigger in the summer of 2007. Smart investors knew this was a bad sign. They got out of the stock market and saved a ton of money. As you likely remember, the S&P 500 peaked in October 2007, and went on to crash 57%.

For the first time in four years, this spread is getting significantly bigger.

As you can see, the U.S. stock market and spread moved together while stocks were in a clear-cut bull market through mid-2014 (the spread is inverted on the chart below). Then, they diverged. The spread has more than doubled, while the S&P 500 remains near all-time highs.

This is another reason to be very cautious in the stock market today.

This article by Justin Spittler first appeared on Casey Research on 11 December 2015.

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