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Forget Oil, Is It All About Russia Now? image

Worries abound in the stock market these days as traders fret about the price of oil, deflation, high yield bonds, the global banking system, the economies of Europe, China, and Japan, what the Fed will do next (and when), and Russia. It's that last one that seems to be attracting the most attention at this stage. As such, it is a good idea to understand why Russian stocks and the country's currency has any bearing whatsoever on the stock and/or bond markets here in the good 'ol USofA.

While trying to predict the outcome of crises can be problematic (if not a fool's errand), understanding why a crisis is occurring is vital. If investors can thoroughly understand WHY the markets are doing what they are doing, it can be much easier to deal with the price action on a daily basis. The key is to understand that a lack of understanding creates fear, and fear can lead to trading on emotion - and we all know how that tends to turn out.

Remember, a big part of the problem for investors in 2008 was the fact that very few outside of Wall Street really understood the mess that was happening in the credit markets in response to the alphabet soup of securities that were imploding. Few, if any, investors understood the ramifications of the credit markets freezing. And not many folks could comprehend what would happen if money market funds "broke the buck."

So, while the current decline in the stock market may not qualify as a full-on crisis at this stage, it is still probably a good idea to understand why stocks have been diving alongside the price of oil.

Forget Oil, It's All About Russia Right Now

I know what you're thinking, "Wait, what? I thought this market was about oil. How the heck does Russia fit in?"

We have spent a fair amount of time talking about oil lately. And thanks to Dr. Robert Barone for providing a professional economist's point of view on the subject yesterday. However, at this stage of the game, the action may be more about Russia than the price of "Texas Tea."

First, let's look at the Russian stock market, which has been just plain ugly lately.

Market Vectors Russia ETF (NYSE: RSX) - Weekly

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As the chart clearly shows, Russia has been a miserable place to invest for years now. However, the carnage has definitely accelerated in 2014 as the Russian ETF (NYSE: RSX) has fallen more than -47% since mid-year alone!

Next up is the country's currency: the ruble. To say that the ruble has been falling would be an understatement. No, put succinctly, the ruble has collapsed as the currency has been hitting all-time lows against the U.S. dollar this week.

So, between the action in the stock market and the ruble, it is safe to say that there could be an economic crisis happening in Russia. But again, why should you care?

Markets Have Long Memories

Given that I have a meeting with investors later this morning, I'm going to cut to the chase here. The bottom line is that the situation is Russia could very easily become the next big crisis in the markets.

Anyone who has been in the game a while will remember what happened in 1998, which is commonly referred to as the "emerging markets crisis." While stocks in the U.S. did not officially enter a bear market, it was a very close call.

If you will recall, it was Russia defaulting on debt payments that started the problem. And before long, one of the biggest hedge funds in the world - Long Term Capital Management - was in trouble and needed to be bailed out by Wall Street. Recall that the geniuses that ran LTCM had all the right pedigrees and a couple of them had even won the Nobel Prize for their work on valuing derivatives. However, in a classic case of book-smart vs. reality on Wall Street, the fool-proof approach used by LTCM never imagined that a country like Russia could default on debt or that the implications of such an event could cause their approach to crash and burn - OR - that a hedge fund collapse could threaten the banking system.

Getting back to the point, the problem is that Russia is now in a world of hurt and this could create a spillover effect into the emerging markets, involving currencies, stock markets, and credit markets. In short, the worry is that the problems in Russia could trigger the next emerging market crisis.

We saw hints of this yesterday, as the yield on the U.S. 10-year bond suddenly declined in earnest. This was the first REAL clue that there may be problems afoot as investors tend to flock to the relative safety of U.S. bonds during times of crisis. As such, we would continue to watch the yield on the 10-year as a proxy for whether or not an actual crisis is at hand.

The Bottom Line

So, is a -4.95% decline in the S&P 500 enough to discount the potential fallout from the debacle in oil and Russia? This is the real question at hand right now (well, that and if the "considerable period" language will come out of the FOMC statement - we say, yes).

Just this morning, there is a report that MSCI could exclude Russia from its emerging market index. And if this occurs, think about the amount of money that will be FORCED to sell Russian equities due to indexing. Yikes.

But the key is to understand that none of us knows how this situation will play out. Sure, you can place a bet on the outcome. And if you bet that the U.S. stock market will survive, you will likely win in the long run. However, it is not inconceivable to say that things could get uncomfortable for a while.

So, while our crystal is in the shop (still), we can try our darndest to understand the questions facing the markets at this point. And this is what this morning's missive has been about.

Turning To This Morning

This morning's action is again all about Russia. Sure, there is an election coming up in Greece and Janet Yellen will talk to us today about the outlook for monetary policy and the economy in the U.S. However, the fact that the Russian Foreign Ministry decided to defend the ruble. In an attempt to stem the selling in the country's currency, Russia's Deputy Finance Minister Alexei Moisseyev was quoted as saying they will be selling "for as long as we need to". Many believe the move is seen as being (1) odd that the Russian Central Bank was not involved and (b) behind the curve. Reports suggest that Russia will need to take more aggressive action in terms of currency intervention and that capital controls may be needed to stem ruble pain. Here at home, all eyes will be on the Fed this afternoon as the FOMC is likely to remove the "considerable period" language from the FOMC statement describing how long rates are likely to stay at record lows. Traders will also be listening intently for any mention of the action in oil or the goings on in other parts of the world. U.S. stock futures are currently following the action in the ruble and point to a rebound at the open on Wall Street.

Pre-Game Indicators

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

Major Foreign Markets:
    Japan: +0.39%
    Hong Kong: -0.37%
    Shanghai: +1.31%
    London: -0.85%
    Germany: -1.03%
    France: -0.79%
    Italy: -1.83%
    Spain: -1.19%

Crude Oil Futures: -$0.98 to $54.95

Gold: +$4.70 at $1199.00

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

10-Year Bond Yield: Currently trading at 2.093%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +10.10
    Dow Jones Industrial Average: +88
    NASDAQ Composite: +22.30

Thought For The Day:

Happiness is in the heart, not in the circumstances. - Author Unknown

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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