A quick note on yesterday’s drop in the markets and our short-term outlook:
The focal point is oil, which appears to be nearly through in its correction, with each successive decline impacting other markets due to leverage, and to a lesser extent supply/demand. Investors should keep in mind that refineries have little interest in taking in significant new inventories of crude at present, due to seasonality. In a month or so, production slates begin to switch focus from home heating oil to gasoline, which likely boosts demand and relieves some pressure on prices. The leverage unwind is twofold; the direct part where oil is used as collateral for debt and derivatives, and indirectly as a highly liquid global security. Oil is in close company with copper, 10Y UST’s, S&P futures and currency pairs. Through the last several years of credit-fueled market advances, shorting the USD and going long the most liquid securities and derivatives led these markets to have correlations greater than 90%. While this has subsided, record global leverage ensures that if one moves, it affects the others.
Another proximate driver is currency. The Fed balance sheet saw a decline at the end of 2014 but this was not attended by higher rates. Absent this, the pressure is relieved by a stronger dollar. Dollar strength is amplified by resurgent deflation among our trading partners and its effects on their currencies; i.e., EUR, JPY, GBP and especially the RUB. These relationships can be stretched for a while, but eventually they must balance. An apt description of the macro environment is a Keynesian curve with an Austrian fat tail.
This brings us around to risk appetite. Sector rotation last week shifted away from cyclicals towards the defensives. Credit spreads, which had narrowed August through mid-December, widened the last two weeks. Both appear to be short-term events. Importantly, until alternatives to equities look superior, or at least equally attractive overvalued, overbought market conditions can persist.
Short-term, it is less likely the downswing in equities is complete. The 60-minute and daily charts show meaningful support near 2,019 and the intraday chart reads oversold, allowing for at least a bounce. The S&P 500 retraced an important 61.8% of the December rally. We suspect that this could be followed by another less aggressive shakeout, with a more meaningful rally to follow. Seasonality favors a stronger January fading into early February, which then starts to gain ground steadily from March on. For traders, this assumes that support around 1,972 to 1,976 is not violated.
Intermediate-term, the advance in equities appears intact. Please contact us for more details.
Managing Director, Chief Market Strategist