More rough going ahead on Wall Street
Not since the recession was in full swing have stocks performed as poorly as they have at the start of this year.
On Tuesday, the Dow Jones industrial average lost another 0.7 percent to close at 17,371 as ongoing weakness in crude oil weighed on sentiment. The S&P 500 lost 0.9 percent, dropping to 2,002, for its fifth straight decline.
Crude oil lost another $2.18 a barrel to finish at $47.86. Gold and silver moved higher. And U.S. Treasury bonds surged in a bid for safety, pushing the 10-year yield below 2 percent for the first time since early 2013.
This has been a brutal losing streak for equities, but a look at the evidence suggests the selling is far from over.
The collapse in energy prices raises concerns not only about the profits of energy companies but calls into question the health of the high-yield bond market, the stability of oil-exporting economies and the vitality of the global economy. Back in November and December, when this story was fresh, stocks rose anyway.
What changed is that the oil slump has deepened to such an extent that much of the U.S. shale oil industry is now unprofitable. According to estimates by analysts at WoodMackenzie, oil needs to be near $70 a barrel for these companies to break even on a short-term basis. For prices to stabilize, production will need to be curtailed. Investment spending will need to dry up. Earnings will be pinched. And contagion will spread to other areas of the economy.
We're already seeing this play out as the meme shifts from the positive impacts of cheaper oil on middle-class families to the negative impacts on the corporate sector and the stock market. Among those downsides: lower earnings, lower capital spending and the risk the oil price drop reflects a downturn in global economic fundamentals.
Caterpillar (CAT) has been hit hard this week after analysts at JPMorgan (JPM) downgraded the stock to underweight because of its exposure to the energy sector, which accounts for 12% of revenues, as well as to emerging market economies (which are also being pulled down by cheaper oil). U.S. Steel (X) announced on Tuesday that it would lay off more than 750 workers in Ohio and Texas on lower anticipated demand for steel pipes as oil and gas companies pull back on exploration and investment spending.
But now, new wrinkles are starting to appear.
One is the situation in the eurozone as Greece looks to be on the verge of voting the anti-bailout/anti-austerity Syriza party to power -- potentially unlocking a wave of nationalist victories in countries such as Italy and undermining the narrative that has helped quell Europe's debt crisis since 2012. This included the idea that the euro was irrevocable and that a government bond-buying stimulus program from the European Central Bank was inevitable. Both are in doubt now.
Two, market technicals are looking less favorable. Stock market breadth, or the percentage of stocks participating to the upside, has been narrowing since the summer. Investor sentiment, as measured by the share of stocks vs. cash in individual portfolios, has swelled to an extreme not seen since the 2000 dot-com peak according to the team at SentimenTrader. And the relationship between stocks and bonds suggests smart money traders are preparing for trouble.
Three, the policy environment is poised to become far more difficult with budget battles looming in Washington and the Federal Reserve preparing to raise interest rates for the first time in nine years.
And four, amid all this, valuations are looking pretty steep. In a note to clients on Monday, David Kostin at Goldman Sachs (GS) highlighted that the median stock in the S&P 500 trades at a median forward price-to-earnings multiple of 18x -- a level experienced only 2 percent of the time since 1976. The 35-year average is near 13x. These multiples have come as a result of the nearly unbroken uptrend stocks have enjoyed since 2011.
With all this in mind, the excitement over that Santa Claus rally heading into the Christmas holiday looks, in retrospect, like a wee bit of escapism before reality came rushing back in. Right now, it's still coming in.
