More High-Yield Defaults on the Way?

Many experts have been dismissive of bond liquidity fears: Vanguard’s global head of fixed income, Greg Davis, said concerns were “a bit overblown” just a few months ago. Friday’s selloff in high-yield bonds proves these fears were well-founded.

All of this further raises the stakes for this week’s Federal Reserve policy decision, since the start of a policy-tightening campaign will only further encourage investors to sell high-yield bond positions on yield sensitivity and rising default risk among highly leveraged energy companies.

Already, according to FactSet, S&P 500 energy sector earnings are expected to decline a whopping 65% in the fourth quarter vs. a year earlier.

No surprise then that energy stocks led the decliners last week, falling 3.4% as a group Friday. Exxon Mobil(XOM) lost 1.8% while Chevron(CVX) lost 3.2%.

Smaller, more indebted companies like Chesapeake Energy (CHK) and Bonanza Creek (BCEI) were down 8%. Chesapeake is the poster child for these issues; it’s down 84% since June 2014 after over-expanding on cheap credit. Bonanza is down 87%.

Many of these smaller companies will almost certainly default on their high-yield debt and will in turn either go bankrupt or sell themselves off at pennies on the dollar. Many others, as we have been discussing for months, will be forced to write down the value of their oil and gas in the ground, especially as their hedges roll off. This is all in front of us and it will not be pretty.

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Friday’s large-cap breakdown only confirmed weeks of warning from areas like transportation stocks, small-cap stocks, utility stocks, commodities and credit. All have been weakening while the Dow held near the 18,000 level. It also confirmed technical signs something was amiss, such as oddly weak market-breadth measures as fewer and fewer stocks held the major averages aloft.

That’s all changing now, as many realize the end of the Fed’s 0% interest-rate policy might not be as benign as they had hoped.

Weak underlying conditions were what my Tech Trend Trader market timing system has been warning about for two months. It is a long-range model that measures the underlying strength in the economy as well as stock valuations to make its judgments about whether it’s a good time or not to be in the market. It was early this time, to be sure, but it looks like it was right. The system is up 6.1% so far this year, vs. the 3% loss for the broad market.

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OK now a little good news from the data hounds.

Jason Goepfert of Sundial Capital reports that the market losses last week triggered a 65% jump in the S&P 500 Volatility Index ($VIX), or “fear gauge,” through Friday. That was one of its largest one-week moves in history, particularly when the VIX had been low.

Because volatility has been so low, this is actually the third occurrence in a year, Goepfert reports. After both of the others, stocks rose over the next week, plateaued, then rose again in the medium term. That was mostly the case going back further as well.

The sample size is small, so the most you can really say is that these volatility shocks did not lead to consistent downside, Goepfert concludes, which is always the worry when we’re trading near multi-year highs and see a shock. So it’s a positive, but not a huge one.

Meanwhile, one of my longtime sources in the historical data analysis community, who I can only identify as AK, reports that since 1990, when the S&P 500 has lost more than 1.5% on a Friday, the odds are 78% that there will be a lower low at some point on the ensuing Monday. However, the Dow Jones Industrials are actually up 55% of the time on the following Monday, so you might get a lower low but end higher.

Moreover, AK reports that the Dow has been down 2% or more at some point in December twenty-five times in the past century. From that date to Dec. 31, the odds are 72% that the Dow will be up and by an average of a whopping 4%. In the down cases, the Dow has only been down 2% on average. So the risk/reward balance favors the bullish case. And we already know that the second half of December is stronger than the first half, historically.

Bottom line is that the bulls are probably not going to give up easily. Since the Fed announces its next policy move Wednesday, perhaps a positive reaction by the market will be the catalyst for unexpected strength.

More broadly, there is an epic battle going on now between bulls and bears as each side believes strongly they are right and are willing to fight. For the first three sessions of the week, the bears had the upper hand and were helped by bad news out of China, as well as plunging oil prices. Then on Thursday, the bulls managed to block them.

From a seasonal point of view, we will leave the historically weak first half of December this week and enter the historically strong second half of the month. But seasonal trends are only a mild tailwind, and fresh views of the health of the global economy — and central banks’ response — will continue to be the dominant theme at this time.

Jason Goepfert rifled through his database to determine how the market performs in the last three weeks of December when the S&P 500 is negative through the first week of December. It turns out that whether you buy that benchmark index or the Russell 2000, the results in the last three weeks of losing years has been mostly positive.

Even though “everyone” knows about positive year-end seasonality — the famed Santa Claus rally — it has remained in effect for decades. There’s still another week or so of a weak spot, however, so there’s no need to rush out and raise exposure to stocks yet if you have cash laying around. But if the market is soft through the middle of next week, and you have a contrarian streak, it’s probably a good time to push in some chips and make a year-end bet.

Best wishes,

Jon Markman

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