Daily State Of The Markets: It's About Oil, And Junk, And...

Includes: DIA, IWM, QQQ, SPY, USO, UUP
by: David Moenning

What a difference a week can make in this game, eh? What's interesting here is that things are traditionally kinda quiet at this time of year. However, while I spent last week running from meeting to meeting, the stock market appears to have embarked on a course correction that just might turn out to be meaningful.

At this stage of the game, I am not completely sure which is the more important focal point in the market. However, it is clear that traders were able to find a handful of reasons to do some hand-wringing last week.

First, there was the resumption of the decline in oil. As we've discussed a time or two lately, oil is viewed by traders (and their computers) as a proxy for global growth. And from a big picture standpoint, the fact that China's economy is slowing faster than expected and the economies of both the eurozone and Japan continue to struggle, a decline in oil is to be expected.

However, as the chart below shows, this does not appear to be your run-of-the-mill pullback in oil/commodities.

United States Oil Fund (NYSE: USO) - Weekly

No, this decline has become monumental. To put things in perspective, the chart shows that oil fell about 50% during the second half of 2014. And then the price of "Texas Tea" has fallen nearly 50% again from the summer highs seen in 2015.

To be sure, concerns over the state of the global economy - aka the demand for oil - is in play here. But a decline of more than 70% over 18 months suggests that there is more at work than China's GDP growth rate falling from 8% to 6.5%.

Another factor that has historically been considered in the price of oil has been the U.S. dollar. Since oil is priced in dollars around the world, a rising dollar is usually a problem for crude. However, take a look at the chart below. Given that the dollar actually fell last week, we can't blame the action in the greenback for the renewed plunge in oil.

PowerShares US Dollar ETF (NYSE: UUP) - Daily

Traders focused on the oil pits also spend a fair amount of time looking at oil supplies around the world. So, the fact that there were reports of a worsening oil glut probably didn't help pricing last week.

And then there is OPEC. Cutting to the chase, with no production cut coming out of the most recent OPEC meeting, it wasn't surprising to see crude futures take it on the chin.

Although the cartel itself has lost most of its teeth over the last decade or so, folks do continue to listen intently to what the Saudis have to say. And the bottom line here is that the world's largest producer of oil appears to be on a mission to cement their market share.

It is important to note that this is not the first time the Saudis have made such a play. The idea is to drive prices down in order to knock out the competition. Yes, it is actually that simple.

Fallout in Junk Bonds

Whenever a market moves to the degree that oil has over the last year and a half, there is always fallout from the move. And another major concern in the stock market at the present time is the action in the high yield/junk bond arena.

I have managed money in the high yield bond market since 1993. Two of the biggest lessons to learn about managing the cycles of this market are: (1) junk bonds are really "stocks in drag" and (2) these bonds trade primarily on credit risk - i.e. the risk of default.

So, with oil prices having been crushed and something like 40% of all junk bond issuance over the last few years coming from energy companies (think the Bakkan shale boom) the risk of default in this market has skyrocketed of late. And what does that mean to the junk bond market, you ask? In short, nothing good!

The trade here is simple. With oil breaking down to new lows last week, the price of the junk bond funds/ETFs went the same direction.

iShares IBOXX High Yield (NYSE: HYG) - Daily

The picture is even worse when you back it up a bit and look at the price of the HYG on a weekly basis.

iShares IBOXX High Yield - Weekly

Another key to the puzzle in the junk market is the fact that a couple funds announced last week that they were no longer accepting redemptions. Make no mistake about it folks, this is what happens when things get really bad in a market. Funds start to blow up. And then the risk of contagion comes into play.

According to Carl Ichan, "the meltdown in High Yield is just beginning." And the bottom line here is that investors are voting with their feet. BofA/Merrill Lynch says that outflows from junk bond fund totaled $3.8 billion last week, which was the highest amount seen in the last 15 weeks.

The problem here is that this situation causes liquidity to shrink - dramatically. And what happens to a market when there are more sellers than buyers? Oh, that's right...

Why Do Stock Market Investors Care?

The end result of the trash job in oil and junk was a losing week for the major stock market indices as well. Stocks wound up falling four of the five trading days. And then, perhaps more importantly, the S&P 500, midcaps, and smallcaps all broke down through important support levels on a chart basis.

S&P 500 - Daily

The question, of course, is whether or not the price action seen in the S&P is meaningful, or simply another fine example of algo-induced hysterical trading.

So tomorrow, we will take a look at the indicators to see if there are any clues...

Today's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:

Japan: -1.81%

Hong Kong: -0.72%

Shanghai: +2.52%

London: -0.06%

Germany: -0.84%

France: -0.34%

Italy: -0.90%

Spain: -0.64%

Crude Oil Futures: -$0.89 to $34.73

Gold: -$8.30 at $1067.40

Dollar: higher against the yen and pound, lower vs. euro

10-Year Bond Yield: Currently trading at 2.147%

Stock Indices in U.S. (relative to fair value):

S&P 500: -5.15

Dow Jones Industrial Average: -43

NASDAQ Composite: -8.45

Thought For The Day:

"Don't forget, ego is the real enemy in this game" -- Yours Truly

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of Oil's Dive

2. The State of Global Central Bank Policy

3. The State of Global Growth The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Moderately Negative

(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral

(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Moderately Positive

(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 2020, 1990
  • Key Near-Term Resistance Zone(s): 2135

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Negative
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator(NASDAQ): Negative
  • Breadth Thrust Indicator (NASDAQ): Negative
  • Short-Term Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Negative

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:

    - Short-Term: Oversold

    - Intermediate-Term: Moderately Oversold

  • Market Sentiment: Our primary sentiment model is Negative

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Neutral