Financial Review

Buckle Your Seat Belts

Financial Review
DOW – 331 = 17,501
SPX – 37 = 2020
NAS – 74 = 4652
10 YR YLD – .08 = 2.04%
OIL – 2.82 = 49.87
GOLD + 15.40 = 1206.20
SILV + .40 = 16.29

If Santa Claus should fail to call, bears may come to Broad and Wall. That is the old saying and most people think the Santa Claus rally covers the month of December, or maybe the week leading to Christmas; actually, the rally time frame covers the last 5 trading days of the year and the first 2 trading days of the New Year, which would include today. And today the markets were down; the worst day in 3 months. The Santa Claus rally is really an indicator.

In 1999-2000 rally timeframe suffered a horrendous 4% loss. According to the Stock Trader’s Almanac, on January 14, 2000, the Dow started its 33-month 37.8% slide to the October 2002 midterm election year bottom. NASDAQ cracked eight weeks later falling 37.3% in 10 weeks, eventually dropping 78% by October 2002. Saddam Hussein cancelled Christmas by invading Kuwait in 1990. Energy prices and Middle East terror woes may have grounded Santa in 2004. In 2007 the third worst reading since 1950 was recorded as subprime mortgages and their derivatives lead to a full-blown financial crisis and the second worst bear market in history.

For the past 4 trading sessions, the S&P 500 is down. The S&P 500 hasn’t had a 4-day losing streak in 264 trading days. This is the longest such streak without a 4-day decline since 1928. Which means that over the past 87 years, we’ve seen a whole bunch of 4-day losing streaks; that is the norm, but since 2013 we’ve gone through a period where stocks just haven’t gone down. Maybe you’ve been lulled into a sense of complacency.

The S&P 500 finished 2014 up about 11%to post the sixth consecutive year of positive returns. Since 1927, there have only been two periods that the S&P has had longer winning streaks. From 1982 to 1989 the S&P rose for 8 straight years, and that includes the crash of 1987, where the S&P still managed a small gain for the year. Between 1991 and 1999 the S&P rose for 9 straight years, but only if you reinvested dividends in 1994. And if you want to use the entire month of December as an indicator, well, December 2014 was the third weakest December since the turn of the century; only 2007 and 2002 were weaker. Now, consider that both 2002 and 2008 were very weak market environments and 2014 was relatively strong.

So, the question is “can the S&P 500 post gains for a seventh straight year?” And the answer is that I don’t know and you don’t know, and the talking heads on TV and the internet bloggers don’t know. What history tells us is that a bull market doesn’t last forever. Eventually and inevitably, stocks will drop; it could happen this year, or not; maybe next year, or not. Maybe the bears are coming to Broad and Wall, or not.

What we do know with some certainty is that the bears have come to the oil patch. US crude dropped more than 5% today, dipping below $50 a barrel for the first time since May 2009. And even as prices have dropped, production remains high. Russia’s oil output hit a post-Soviet high last year, and Iraq’s oil exports in December were highest since 1980. ConocoPhillips announced it struck first oil at a Norwegian North Sea project. Saudi Arabia cut prices for European buyers.

Open interest for $40-$50 strike puts in US crude have risen several fold since the start of December, while $20-$30 puts for June 2015 have traded. Meaning there are some people willing to gamble that oil could hit $20; that is a big gamble, but some people are taking the bet, or at least they are buying some insurance against falling prices. And that brings us to the shale producers in the US. Saudi Arabia is trying to gain market share and edge out US shale producers with lower prices, calculating that the 50% drop in oil prices will force US oil companies to drill fewer new wells, causing US production growth to stall and putting a floor under oil prices. But the shale players have, by and large, hedged their positions and insured against lower prices. If prices continue to fall, the US oil producers will eventually be exposed to low prices, but for now they are like the little Dutch boy with a finger in the dike.

New hedging strategies are only likely to get disclosed in quarterly earnings reports in late January, so for now we don’t know how much hedging is really going on. A rough gauge of hedging activity is to look at net short positions of oil producers and other non-financial companies in the US crude oil futures and options markets, and those net short positions have grown from 15 million barrels in August to more than 77 million barrels last week. For many companies that set up “in the money” hedges prior to the slump, the downturn offers a chance to cash in or extend their protection.

For example, a company that had sold swap contracts to hedge a part of its 2015 production at $90 a barrel, essentially shorting forward oil prices to guard against a drop, could buy them back now at around $57 for a profit of about $33 a barrel. They could then roll that over to shield themselves against a further market slide by buying swaps and options pegged closer to current prices. With the December 2015 put option for $60 a barrel now trading at around $9 a barrel, swaps cashed in now could buy a producer nearly four times more protection at that price. There are, of course limits to this strategy. If prices continue to slide, it will eventually result in cutting off production. We just don’t know the “if or when or level” of the cut-off point.

Meanwhile, the lower prices are rippling out beyond the oil patch. Today, JPMorgan downgraded its rating on Caterpillar citing concerns about the company’s exposure to oil and gas, and indirect exposure to mining, construction and emerging markets. Caterpillar supplies turbines to offshore rigs, as well as reciprocating engines and transmissions for on-site drilling. It also provides construction equipment that is used in infrastructure development, along with aftermarket and other services. Caterpillar also has exposure to Canadian Oil Sands, which are susceptible to a significant slowdown in demand. Further, the analysis determined that construction equipment demand has been strongly correlated with the expansion of fracking. High oil prices helped spur the boom in fracking, which in turn triggered a boom in construction in places such as North Dakota and other shale oil rich states.

As the price of oil slumps, some companies in the energy industry will go out of business. Not only will that cost jobs in the sector, but it will also cut spending on things like plants and equipment. Today energy stocks led the drop on Wall Street, down about 4%.

Which all sounds rather ominous, but I’m not finding many people crying for the big oil companies. Yesterday I filled the tank on my car and paid $1.89 at the pump, saving about $20 or so compared to what it cost me to fill the tank in January of 2014. Repeat that transaction with millions of American drivers and pretty soon you’re talking about real money. Thank you very much.

The big economic news this week will come on Wednesday and Friday. Wednesday features the release of minutes from the Federal Open Market Committee meeting in mid-December. That will likely be secondary to the Friday jobs report. You will recall that last month’s jobs report showed a big spike in jobs in November. The first guesstimate for November came in at 321,000 new jobs. Friday’s report is expected to show somewhere around 220,000 new jobs for December; which would mean the economy might have generated nearly 3 million new jobs in 2014, the best performance since the US created some 3.2 million jobs in 1999. The economy added an average of 241,000 jobs a month through the first 11 months of the year, up 24% from a 194,000 pace in 2013. Over the past 3 years, the unemployment rate has dropped from 8.6% to 5.8%, and at some point you might imagine this would lead to some increase in wages, which have been flat lining. One reason for stagnant wages is that there are still a lot of people who want a full-time job but can’t find one, some 18 million people are in that category or long-term unemployed or underutilized; that’s down from a high of 27 million but still about 5 million from where it should be and where it would take the slack out of the labor market.

And I couldn’t finish out this first Financial Review of 2015 without another edition of “Banks Behaving Badly”. JPMorgan Chase has become the first bank to settle a US antitrust lawsuit in which investors accused 12 major banks of rigging prices in the $5 trillion-a-day foreign exchange market. Last November JPMorgan paid $4.3 billion to settle a separate lawsuit with US and European regulators (actually agreed to pay $4.3 billion but only paid about $600 million to date). The US Department of Justice is among the government agencies that are still investigating the issue. New York’s Department of Financial Services is also conducting its own probe.

Terms of today’s settlement were not revealed. Settlement papers are to be filed with the US District Court in Manhattan later this month. In their complaint, investors including the city of Philadelphia, hedge funds and public pension funds accused the 12 banks of having conspired since January 2003 in chat rooms, instant messages and emails to manipulate the forex markets. The 12 banks held an 84% global market share in currency trading, and were counterparties in 98% of US spot volume.

Meanwhile, the euro dropped to its weakest levels since 2006. ECB president Mario Draghi is looking at the prospect of deflation in the Eurozone which might lead to large scale sovereign bond purchases. Italy is experiencing a triple dip recession, France is struggling, Germany is being dragged down, in part due to their own intransigence, and Greece; well, nobody is even sure Greece will stay in the Eurozone. And this all affects the larger multi-national US corporations that do a substantial amount of business in Europe.

More on that in the coming days.

Happy New Year. Buckle your seat belts.

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