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5 "Tells" that the Stock Markets Are About to Reverse

The Damage Caused By the Oil Bear Will Spread Far and Wide

Commodities / Crude Oil Dec 21, 2014 - 06:14 PM GMT

By: Money_Morning

Commodities

Michael E. Lewitt writes: Oil prices continued to fall this week but stock markets shrugged off the disarray this continued to cause in global markets after Janet Yellen whispered soothing words in their ears after the Fed's last meeting of the year on Wednesday. Mrs. Yellen has become a "bull whisperer" – fearful of upsetting the equity market, she cloaks her words in indirection and equivocation in an effort to keep them calm as she prays for an economic lift-off that will take her institution off the hook.

Unfortunately, her patient is likely to be very disappointed, for it would take an economic miracle the likes of which hasn't been seen in this country since the years after the Second World War to deal with the mountain of existing debt and future liabilities that are going to bury us.


For the moment, however, the bull was assuaged with the Fed's promise that it would be "patient" before raising interest rates, unleashing a furious charge that reversed almost all of the 4.8% that the market lost over the previous six days.

Strange Things Happen on Quadruple Witching Day

The Dow Jones Industrial Average closed the week up 3% at 17,807.37, 150 points below its all-time record closing high of 17,958.79 on December 5. Only two days before, it had closed at 17068.76. The S&P 500 closed up 3.4% at 2070.73, a mere 5 points off its record closing high on December 5 of 2075.37. Two days earlier, it had closed down at 1972.74. The Nasdaq Composite Index closed up 0.4% and ended the week at 4265.38. Friday was quadruple witching day and when the moon is rising all types of loony behavior appears. This week was no exception.

Bond yields backed off with the stock market rally and the yield on the benchmark 10-year Treasury bond ended the week at 2.178% after flirting with the 2% level earlier in the week. The TIPS market is still signaling very low inflation expectations with the 5-year breakeven trading at a remarkably low 1.2% and the 10-year breakeven at 1.65%. These are also levels that previously led the Fed to initiate new rounds of QE the last times we saw them after the financial crisis.

At least one Fed governor, Minnesota's Kocherlakota, appears to be in a panic that the Fed might act to soon to raise rates and create an unacceptable risk that the economy might fall into Japanese-like low inflation funk. It must be mighty cold up there in the northern plains because in places like New York City and Miami, or on the NYSE and Nasdaq, the prices of real estate, art and stocks and bonds are skyrocketing in price and showing little signs that inflation is contained.

Fortunately Mr. Kocherlakota is in the minority; leaving our fate in the hands of former tenured professors is going to be hard enough to explain to our descendents when we have to explain to them why the monetary policies we have followed for the last few years failed so miserably.

Never Mind the Economists, Send in the Psychiatrists

At this point, reading the mind of the market requires a psychiatrist more than an economist and likely it always has. It appears that the Fed blinked once again in the face of market volatility. Rather than telling the market to "suck it up" and prepare for higher rates, Fed Chair Yellen went out of her way to soft-pedal her message. If markets rallied so dramatically at signs that the Fed will be "patient," Lord only knows how hard they are going to sell off when the Fed actually dares to raise rates as they are certain to do one day.

Markets may have paid too much attention to the delivery and not enough to the substance of what Mrs. Yellen said last week. Real U.S. GDP has grown at better than 3.0% for five of the last six quarters, the unemployment is well below 6% and inflation is hovering near 2%. The substantive message from Mrs. Yellen and most other Fed officials (with the notable exception of uber-dove Kocherlakota) is that rates will be hiked in the middle of next year. Based on the stock market rally this week, that does not appear to be a message markets are prepared to hear. The market is still pricing in significantly lower interest rates than the Fed is forecasting over the next one, two and three years.

While the Fed is a notoriously poor forecaster, markets are scarcely better. In view of slowing global growth and steady U.S. growth, the most reasonable expectation is for a flatter yield curve in 2015 with the Fed lifting the short end of the curve and the market pushing down the long end of the curve. That would spell a move toward recession sometime in 2016 or 2017, something few people and the S&P 500 certainly are not forecasting.

Most Forecasts Are Out the Window Now

It will take a while for markets to adjust to the new oil order. According to a recent Bloomberg survey, the median WTI forecast for 2016 is still $86/barrel. In case anybody is looking, that is $33/barrel or nearly 60% above current prices. These forecasts are based on now outdated cost data and will have to be adjusted lower.

Virtually nobody projected the price of oil to drop by more than 40% since the summer, so current projections for it to bounce back should be heavily discounted. It appears that the sharp price drop was caused by both supply and demand factors, neither of which is going to turn around overnight. Furthermore, the sharp drop in oil has begun to create unanticipated consequences that will affect markets in the year ahead, the collapse in the Russian ruble being the first of many.

The carnage in oil stocks and bonds is considerable. The average yield on the energy sector of the high yield bond market, which represents roughly 17% or $200 billion of the market, moved above 10% this week for the first time. To place that in context, this yield was much closer to 6% as recently as the summer. Bonds of some large issuers such as Samson Enterprises have plunged to the high 30s while their bank debt has traded down into the 70s.

The Oil Pain Isn't Evenly Distributed

The market has begun to tier, however, with fracking companies faring much worse than E&P (exploration and production) companies, larger E&P companies faring much better than smaller E&P companies, and refining companies generally faring better than oilfield services companies (although there is a great deal of pricing disparity among the latter two groups).

In many cases, investors are throwing the baby out with the bathwater, however, creating attractive investment opportunities for investors who can identify companies that can withstand tough times. Losses in the bond market are being exacerbated by increasingly poor liquidity as bond dealers step back from the market, a situation made worse by their desire to hold low bond inventories at year end. Tax loss selling in stocks and bonds is also likely contributing to the bloodbath.

The average yield on the Barclays High Yield Bond Index has now increased to 7.3% from as below 5% at one point earlier this year. The question for investors is whether energy will prove the trigger for a long overdue re-pricing of this market, which has been underpricing risk for the last couple of years.

The damage from lower energy prices will radiate into other sectors and some of the sectors that would be expected to benefit from lower oil prices such as retail are suffering their own structural problems. The days of 5% yields are likely over, and it isn't a moment too soon.

Editor's Note: Michael Lewitt publishes the highly regarded The Credit Strategist, and was recognized by the Financial Times for forecasting both the financial crisis of 2008, and also the credit crisis of 2001-2002. His 2010 book, The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons) was included in the curriculum at the University of Michigan and Brandeis University.

Source : http://moneymorning.com/2014/12/21/the-damage-caused-by-the-oil-bear-will-spread-far-and-wide/

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