Why Santa Claus Turned His Back on the Stock Market
Anthony Mirhaydari
It wasn’t supposed to be this way. Investors had every reason to expect stocks to finish the year on a high note, but any Santa Claus rally is in real jeopardy now.
The NYSE Composite Index has plunged below both its 50-day and 200-day moving average for the first time since early October, a dangerous technical condition that presages deeper losses in the days to come. High-yield corporate bonds have been slammed back to late 2013 levels. Fear is in the air as the CBOE Volatility Index (VIX) surges higher. Safe-haven seekers are pouring into Treasury bonds, pushing the 10-year yield to 2.1 percent — a level not seen since June 2013. The bond market is pricing in serious trouble.
Historically, December is the strongest single month of the year for large-cap stocks. Moreover, the S&P 500 posted a consecutive run of 29 days above its five-day moving average — an unprecedented feat. And this comes on the heels of some impressive long-term consistency as well: As of the end of November, the S&P 500 has been above its five-month moving average for 29 months.
Moreover, the economic environment was seemingly favorable. GDP growth has been solid. Job growth has been strong. The drop in energy prices, with gasoline futures down by one-half from their summertime highs, is set to unlock an extra $1,000 or so in annual spending per middle-class household, according to Credit Suisse estimates. And although the Federal Reserve stopped its "QE3" bond buying program at the end of October, and seems to be inching toward the first rate hike since 2006, other major central banks were taking up the mantle of "print now or forever hold your peace."
The Bank of Japan continues its monetary easing, gobbling up not only bonds but a variety of Japanese stocks as well. The People's Bank of China cut interest rates for the first time in two years. And the European Central Bank continues to tease investors about its own program to buy government bonds — with the foreplay going on for more than two years now.
But over the past week, the narrative has unraveled.
For one, the drop in crude oil is getting a little scary as it accelerates. Analysts are also crunching the numbers and realizing that, whatever consumer benefits may come, there will also be a clear downside from all this: Lower energy sector profits, less hiring in the shale states, less investment spending by energy companies (responsible for about a third of overall S&P 500 capex), and the rising risk of a high-yield credit event that could see indebted, high-cost shale oil producers go belly up.
Back in November, Deutsche Bank warned that a drop in crude to $60 a barrel would unleash a broad default cycle in the junk bond market — with ripple effects tearing through a financial system that, doped up on cheap money stimulus, forgot what it was like to operate in a rising rates/falling price environment. Specifically, the Deutsche Bank analysts are looking for the bonds of non-investment grade energy sector borrowers to see a 30 percent default rate going forward.
Barclays Capital believes that the U.S. shale industry needs crude oil at around $80 to break even on a "half cycle" basis; with higher prices required when factoring in "full cycle" expenses such as exploration and financing costs. We're already seeing a response, with the U.S. oil rig count dropping the most in two years as companies like ConocoPhilips (COP) and BP (BP) announce layoffs.
Also, doubts are once again growing about the fate of the Eurozone. The latest ECB policy announcement was met with disappointment (no announcement of sovereign QE purchases) followed by despondency on reports in the German press that dovish ECB chief Mario Draghi no longer enjoyed the support of a majority of ECB policymakers. His ability to push through a big QE program, as has been widely expected, no longer looks like a done deal.
At the same time, Greece is back in the news as political machinations could result in the elevation of the anti-euro/anti-bailout Syriza party in January following snap elections. Given the ongoing financing needs in Athens, such a result could very well result in the "Grexit" or Greek exit from the Eurozone that drove so much of the fear and loathing during the acute phase of the European debt crisis back in 2012.
Moreover, the currency trends that hedge funds and other institutional investors have been using for "carry trades" that fund purchases of stocks and bonds have been rattled in a big way as the Japanese yen has strengthened against the dollar and the euro — a reversal of recent trends that has forced the closing of these currency pair trades.
Situations of market turbulence like we're experiencing now would normally bring out the more dovish members of the Federal Reserve — as happened during the 9 percent selloff into the October low — to talk up the ability of the Fed to restart its bond buying program and/or hold off on interest rate hikes if necessary.
But it has been nothing but radio silence from the folks in the Marriner Eccles Building, the result of a media blackout ahead of this week's policy statement. Given November's very strong jobs report, they are likely to stick to their mid-2015 timing on rate hikes.
The only relief on the horizon could come from stabilization in crude oil prices. But with the OPEC oil sheiks in no hurry to act — given a cold-blooded strategy of undermining the U.S. shale industry to recapture market share — with no plans for an emergency production meeting until January at the earliest, the selling pressure should continue through the end of the year.
