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Making Sense of the Oil/Stock Linkage image

If your response to yesterday's trash job in the stock market was something along the lines of, "Wait, what?" you are likely not alone. Tuesday the stock market dove 220 points in the early going and then recovered almost all of it into the close. Thus, it looked like the dip buyers appeared to be back with a vengeance. But then the very next day, the Dow dove -268 points and the dip buyers were nowhere to be found. So, what gives?

While it may sound a little silly, the U.S. stock market is now trading almost in lock step with the price of oil. Seriously. Look at a 1-minute chart of the US Oil ETF (NYSE: USO) and compare it to the S&P 500. Looks remarkably similar, right? Now compare the result of the S&P to the USO over the last 3-4 days. What you'll find is that when oil goes down, stocks go down - and vice versa. Yep, it's that simple right now.

Granted, this is a very new development as the correlation between oil and stocks has only been in effect for a few days. But this would seem to explain the schizophrenic behavior seen in the stock market lately. The game isn't about the will-they or won't-they situation regarding QE in Europe. It isn't about China's stimulus, Japan's economy, the Holiday Shopping season, the Fed, or even earnings. No, it's about the crash in oil!

And in short, understanding how the computers are playing the game right now may also help you from pulling your hair out.

Why the Linkage?

The logical question, of course, is why are stocks and oil joined at the hip right now? Oil has been crashing for nearly six months now but the stock market is only now starting to notice. Hmmm...

US Oil Fund (NYSE:USO) - Weekly

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To be sure, the weekly chart of the USO is ugly. Now compare that to the chart of the S&P 500 over the exact same time period and it is fairly safe to say that oil's debacle has not been much of a problem for the stock market. So again, why the sudden linkage?

S&P 500 - Weekly

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However, there is another pair of charts that makes the situation a bit clearer. First, take a peek at a daily chart of the USO. But fair warning, those with squeamish stomachs may want to avert their eyes.

US Oil Fund (NYSE:USO) - Daily

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Now peruse the chart below. This is a daily graph of the SPDR High Yield Bond ETF (NYSE: JNK). While the charts are definitely not identical, it is fairly clear that the junk bond market has started to notice the big decline in oil.

SPDR High Yield Bond ETF (NYSE:JNK) - Daily

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The reason here is simple. You see, something on the order of 25% of all junk bond issuances over the past few years have been for companies in the oil business. More specifically, the shale/fracking business.

So, as the price of oil plunges, the default risk for these companies rises - dramatically so. Especially for those companies that are highly leveraged. Therefore, the junk bond market is pricing in the ever-increasing risk of companies defaulting on their bonds.

But frankly, why should the S&P 500 care if a few oil firms go belly up in North Dakota?

Lessons From the Credit Crisis

Lest we forget, one of the key components of the market meltdown of 2008 and early 2009 was that credit dried up - almost completely. Remember, even GE couldn't float commercial paper at that time. Nobody was willing to lend money to anybody else. The credit market has seized.

So, here we go. These energy companies at risk of default due to the dive in crude have lines of credit that they think they can use. However, if things get worse here, banks will likely cut those lines. This will speed up defaults. And the worry is that a credit contagion will follow. Suddenly truckers and railroads are at risk. Etcetera, etcetera.

Just yesterday, there was word that the mess in the bonds of the energy sector is starting to spill over into the chemicals sector. And if this continues to spread, well, you get the idea.

The bottom line is this... Nobody wants to even think about what might happen if the credit markets freeze up again. As such, it appears that a case of sell first and ask questions later may be developing.

What Are Investors To Do?

As has been written a time or twenty here, we don't make predictions or offer up advice in this column. No, we prefer to let our models and systems guide our exposure to market risk. But sometimes knowing and understanding the question at hand is half the battle in this game.

So, the decision facing stock market investors at this stage appears to be fairly straightforward. If you believe that oil is going to continue to fall AND that the decline will create more havoc in the junk bond market AND that the ensuing problems in junk will spread to the banks, and then eventually cause liquidity problems in the banking system, then by all means, head to the sidelines.

If, however, you believe that the contagion argument is a stretch, then any further declines in the stock market will present a buying opportunity.

So, good luck to everyone and as they used to say on Hill Street Blues, "Let's be careful out there."

Turning To This Morning

All eyes are likely to remain on oil today as there is little in the way of overnight news to distract traders and their computers from the price of crude. Asian markets followed Wall Street lower on Thursday. Continued strength in the yen is becoming a problem in Japan as the Nikkei fell for a third consecutive session. In China a report circulated that authorities were making efforts to increase bank lending. This is in addition to expectations that the PBoC will do a system wide Reserve Requirement Rate cut in the near term. In Europe, there continues to be speculation relating to the central bank's implementation of a sovereign QE program sometime in Q1 2015. In addition the German IFO cut its GDP forecast to 1.5% in 2015 from the 2.2% projection in June. Here at home, traders will get weekly jobless claims before the open and U.S. futures are pointing slightly higher in the early going, but are already off their best levels as futures continue to track crude prices.

Pre-Game Indicators

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

Major Foreign Markets:
    Japan: -0.89%
    Hong Kong: -0.90%
    Shanghai: -0.48%
    London: -0.49%
    Germany: +0.33%
    France: +0.05%
    Italy: +0.01%
    Spain: +0.17%

Crude Oil Futures: +$0.17 to $61.41

Gold: -$6.70 at $1222.70

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

10-Year Bond Yield: Currently trading at 2.156%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +4.52
    Dow Jones Industrial Average: +45
    NASDAQ Composite: +5.53

Thought For The Day:

Man does not live by words alone, despite the fact that sometimes he has to eat them. -Adlai Stevenson

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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