One of the fascinating things about markets is their ability to turn. Without apparent reason.
At the end of 2015, the mood was reasonably positive. Sure, the year was an ordinary one, but a rally to finish off had many punters hopeful for what 2016 would bring.
And then 2016 came…
So far it has been relentlessly bad. That continued overnight in the US trading session. The Dow fell 2.2% while the S&P500 was down 2.5%. Oil managed to have a slightly better session overall, but gave up earlier gains by the end of the day. It can’t catch a break.
While everyone is watching oil, iron ore prices continue to slowly melt back towards the December lows. Each bear market rally seems to be weaker than the past one. Yesterday, the price of red dirt in China fell 4.1% to $39.50. China’s better than expected trade data for the month of December clearly didn’t help sentiment.
The ongoing bear market in commodities is old news though. I spent most of last year writing about the inevitability of lower iron ore prices, so this shouldn’t come as a surprise.
As Australia’s most important export, the iron ore price decline is bad news. It will continue to hit the budget throughout 2016. The government must be wondering just when to call an election. It’s never a good time to go to the polls when the coffers are empty!
While the commodity bear is very 2015, the panic selling on Wall Street is a 2016 phenomenon. The mood on the ‘street’ is very different to what it was just a month ago. You have to respect the change of sentiment.
Before looking at some fundamental reasons behind the shift, let me show you a chart first. Charts are important because they contain a lot of information if you know how to read them.
Take a look at the Dow Jones Industrial Index. It shows the Dow over the past five years.
As you can see, after a panic sell-off in 2011, the Dow climbed steadily over the next three years. It began to top out in 2015. Then came the August 2015 plunge, confirming that upward momentum had indeed stopped.
The catalyst for that plunge was the devaluation of the yuan. More to the point, it was the realisation by the market that all was not well in China, and the historic dollar-yuan currency peg was at risk of breaking.
After the panic came calm…then renewed buying. After a sharp break lower from historic highs, markets tend to rally. This is the ingrained, ‘buy-the-dip’ mentality at work.
The strength of this rally is important to observe. If a market can go on to make new highs, there’s not a great deal to worry about. But if the rally falters and makes a lower high (as happened with the Dow) then it’s cause for concern.
The Dow is now approaching the panic low from the August/September 2015 period. It is oversold and so should bounce before hitting the lows. But a change in sentiment is underway. The market vibe is turning bearish. Therefore, you’re likely to see a bounce fade reasonably quickly as the desire to sell trumps the desire to buy.
On the chart, that means you’ll see another lower high, and a turn back down. The crucial test then will be to see if the Dow can hold above support at the 2015 lows. If it can’t, then you’re looking at a pretty big bear market unfolding.
The reason behind the change in sentiment — at least as far as I can tell — is that the crushing bear market in oil is starting to work its way into the financial system. As Reuters reports:
‘Energy-focused regional bank BOK Financial Corp said it expected a big jump in the money it will set aside to cover bad loans owing to an extended downturn in the commodities market.
‘The bank, which primarily operates in Oklahoma and Texas, said on Wednesday it expects provision for credit losses for the fourth quarter to be $22.5 million, nearly four-times the midpoint of the $3.5 million-$8.5 million forecast earlier.
‘“As we are now into the second year of the downturn, during the fourth quarter we continued to see credit grade migration and increased impairment in our energy portfolio,” said Stacy Kymes, executive vice president, corporate banking.’
A regional bank raising a bad debt provision is nothing to get too worked up about. But it’s not going to be the only bank exposed. The market ALWAYS moves ahead of the news.
Have a look at this next chart. It shows the S&P500 financial index…
The worrying thing about this chart is that it shows the financials breaking below the 2015 lows. This is bearish and points to more falls ahead. It looks like the market is discounting rising bad debts in the energy sector.
What’s surprising about all this is that no major company is in any trouble yet. The financials index tells you that might be about to change. How long it will take for the news to surface is anyone’s guess. But the message from the market is to be prepared.
Something is brewing…
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