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Will Oil Trigger The Next Bear Market? image

Oil continued to collapse on Friday, taking the stock market down with it. And while there were other stories that attracted some attention at the end of last week, including London's airspace being closed and a downgrade of France's sovereign debt rating, there can be little argument that oil remains the focal point of the market.

The question of the day is simple... Is the next big crisis upon us? Will oil's crash wind up being the trigger for a bear market in stocks? Is it time to head for the hills?

While no one, including yours truly, can provide the answer to these questions ahead of time, we can do our best to (a) understand the issues at hand and (b) attempt to make an educated guess as to whether the next big thing in the stock market has arrived.

So this morning, we will spend our time looking at the various issues as well as a lot of charts in an effort to try and fully understand what is turning out to be a truly amazing move in oil.

Let's start with an updated chart on a proxy for the price of oil - the US Oil ETF (NYSE: USO).

U.S. Oil ETF (NYSE: USO) - Weekly

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In case this is your first go round, the chart above illustrates what a crash looks like as the USO has fallen -45 percent since the middle of June.

The first point, which should be uber-obvious by now, is that the big dive in oil prices is very good for consumers. For example, in the process of retrieving my youngest daughter from college for winter break (which means the very last tuition payment is just around the corner!), we wound up driving from Des Moines to Denver on Friday. And I can tell you first-hand that paying $2.40 a gallon for gasoline was a shock - in a good way! The thought that leapt to mind when the pump clicked off was, "Wow - that is a LOT less than normal!"

Therefore, it isn't surprising to see that the stocks in the consumer discretionary sector are doing just fine, thank you.

Consumer Discretionary Select Sector SPDR (NYSE: XLY) - Weekly

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However, the first problem to consider here involves the issue of deflation. Remember, in places like Japan and Europe, deflation has become the enemy. And while it sounds truly strange to anyone who has been in the business a while, central bankers are now trying their darndest to get inflation to move HIGHER. And the bottom line here is the massive decline in oil isn't helping the cause.

PowerShares Commodity Index (NYSE: DBC) - Weekly

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You see, commodities are also in crash-mode at the present time. And again, the bottom line here is that a big decline in commodities is deflationary. So, if you are a central banker hoping/praying that your country can grow its way out of its debt/credit/banking problems, the crash in oil and commodities is definitely NOT your friend.

Many analysts argue that the decline in commodities suggests that there is something darker and more worrisome happening in terms of global demand. The thinking is that if demand for commodities is falling, growth rates are sure to follow.

Whenever there is a question about global demand, it is usually a good idea to check in on the message coming from "Dr. Copper."

iPath Copper Subindex (NYSE: JJC) - Weekly

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The message from this chart is a good news/bad news situation. First, the bad news is that the weekly chart of copper is not a happy sight as prices have been trending lower for years now. This is likely due to the death of the commodity supercycle that is occurring in response to the decline in China's building/industrial revolution.

The good news is that (a) the steady decline in copper is NOT new and (b) the price action of this key industrial metal has actually diverged from oil since October. As such, one can argue that global demand for copper (a proxy for industrial growth) is not crashing at this time and that the current problems are isolated to energy.

Next, the Carnage in Junk Tells Us...

Next up is the action in the junk bond market, which has clearly not been good.

SPDR High Yield Bond (NYSE: JNK) - Weekly

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Traditionally, junk bonds are viewed as a "canary in the coal mine" in relation to the health of the overall stock market. The thinking is that as long as junk bonds are trading well it means that the credit markets are functioning normally and there is confidence in the overall economy.

It is important to recognize that high yield bonds are often referred to as "stocks in drag." The key is that when the high yield market enters a negative phase, these bonds act like stocks and as such, provide little protection from a serious decline.

It is also important to understand that junk bonds trade based on default risk. So, when the economy and/or the credit market starts to struggle, the risk of default on these lowly rated bonds rises - and in turn, prices go down. Therefore, analysts look at junk as a warning sign for trouble in the economy/credit markets.

Because of the big dive in high yield prices seen lately, many analysts tell us that we should be worried about the underlying health of both the credit market and the U.S. economy.

However, it is important to note that the high yield bond indices are heavily weighted in the energy sector. As such, it isn't surprising to see the high yield indices diving alongside the stocks of the oil companies.

Then There is the Potential for a 1998 Russia Redux

The next worry associated with the drop in oil is that state of Russia. It is worth noting that Russia's economy is already stinging from the economic sanctions imposed by the west over the situation in Ukraine. But with oil now diving too, the Russian economy finds itself in a world of hurt.

An example of the pain occurring in Russia is the action in the Ruble. In short, the Russian Ruble hit an all-time low against the U.S. dollar last week. Ouch.

Market Vectors Russia (NYSE: RSX) - Weekly

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Lest we forget, it was Russia's default on sovereign debt in 1998 that created turmoil in the financial markets. This purported "black swan" event took down the Nobel Prize-winning wizards at Long Term Capital Management, which caused great pain on Wall Street for a few months.

So, with the Ruble and the Russian economy diving, and less revenues from oil coming in to pay the bills, analysts worry that another emerging markets crisis is just around the corner.

Speaking of Emerging Markets...

iShares Emerging Markets (NYSE: EEM) - Weekly

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Given that many emerging market countries are major oil producers, it isn't surprising to see these countries suffering as well. The key here is again, the risk of default and contagion. Remember, crises in the emerging markets are not exactly new, so traders know how to play this game!

iShares Brazil (NYSE: EWZ) - Weekly

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The chart of Brazil's ETF should paint the picture quite clearly. While an improving economy in the U.S. has caused stocks to hit all-time highs recently, the stock market in Brazil (and most other emerging markets) continues to stink up the joint. And if the message is that economic conditions are continuing to weaken, can a big increase in default risk be far behind?

But Remember, It's REALLY All About the Banks!

Perhaps the most important thing to remember about any type of crisis that impacts the stock market is that, in the end, it's really all about the banks. A few oil companies, or even an oil-producing country or two defaulting on its debt doesn't really impact the earnings of IBM.

No, the real key is the risk of contagion and how it might affect the health of the global banking system. Remember, this is what the 25 percent decline seen at the beginning of 2009 was all about. The fear was that the system was on the brink of collapse and that if bank runs began, they couldn't be stopped.

So again, the real key here is the banks...

KBW Bank Index - Weekly

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The good news (no, make that, the "really good news") is that there is no sign of panic in the U.S. banking index at this time.

Compare the chart above to the chart of the banking index in 2007-09.

KBW Bank Index - Weekly (2006 - 2009)

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The important takeaway here is that the banking index began breaking down in mid-2007, long before the overall stock market debacle began. Then the index continued to dive into early 2009 as traders became increasingly worried about the state of the global banking system.

Thus, the banking index was a KEY early-warning sign that there was trouble in paradise in 2007!

So... What is this index telling us now? Not much actually, as the index is just 5 days removed from an all-time high. This suggests that traders do not see any real threat to the banking system at this time. Therefore, one can argue that the current crisis in oil is NOT likely to trigger a bear market in the near-term.

However, it is always a good idea to remain flexible and to keep your eyes and ears open. It might also be wise to keep your risk management toolbox close at hand. Remember, you just never know what is going to happen next in this game - so you've got to be ready.

Turning To This Morning

Although the focus remains on oil, there are other stories in the markets as traders begin the last full week of the year. First, Japan's PM Abe maintained his party's super majority on Sunday's elections. Next, it is a merger Monday as there are a couple of new deals happening. In Europe, there is more talk about the ECB going down the QE path as Bloomberg's survey shows 90% of respondents now expect sovereign bond buying to begin in 2015 - up from 57% last month. Speaking of central banks, the FOMC meets this week and the big debate is whether the "considerable time" verbiage will remain in the statement. And on the oil front, prices are being buoyed by tensions in Libya. U.S. futures currently 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: -1.57%
    Hong Kong: -0.95%
    Shanghai: +0.50%
    London: +0.20%
    Germany: +0.41%
    France: +0.61%
    Italy: +0.86%
    Spain: +1.01%

Crude Oil Futures: +$0.18 to $57.99

Gold: -$13.70 at $1208.80

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

10-Year Bond Yield: Currently trading at 2.127%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +10.82
    Dow Jones Industrial Average: +99
    NASDAQ Composite: +28.72

Thought For The Day:

Even if you're on the right track, you'll get run over if you just sit there. -Will Rogers

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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