Down, Down, Down Goes the Dow

Traders and investors, warm and jolly from the holidays, got an ice cold splash in the face as markets reopened, kids went back to school, and 2015 started in earnest. It wasn’t pretty, with stocks suffering their worst Santa Claus rally since 1999.

In the end, the Dow Jones Industrial Average lost 331 points, or 1.9%, to close down more than 600 points from the record high set on Dec. 26. The S&P 500 lost 1.8%, the Nasdaq Composite lost 1.6%, and the Russell 2000 lost 1.5%.

The drivers of the day were renewed weakness in crude oil (which fell 5.3% to $49.90 a barrel, weakest since early 2009) and concerns that Greece could exit the eurozone following snap elections on Jan. 25.

Dow Jones industrial average

European bourses and energy stocks at the epicenter of these two catalysts were hammered, with the iShares MSCI Germany Index Fund (ETF) (EWG) down 3.5% while the Energy Select Sector SPDR (ETF) (XLE) lost 4.1%.

Caterpillar Inc. (CAT) was hit with a 5.3% loss after analysts at JPMorgan downgraded the stock to “underweight” on exposure to the energy sector, which accounts for 12% of revenues, as well as emerging market economies (which are also being pulled down by cheaper oil). The Jan $92.50 puts I recommended to Edge Pro subscribers are up more than 193% since recommended Wednesday.

caterpillar cat stock chart

Technically, a pullback was due after the Dow Jones zoomed more than 1,000 points higher in the six sessions heading into Christmas Eve on light volume and narrow breadth. At its peak, just 62% of the stocks on the NYSE were in uptrends vs. the nearly 75% seen back in November and the nearly 85% reading set back in July.

In other words, stocks were chugging higher on a narrowing base of support and were vulnerable to a pullback. Declines in October and in December were arrested by dovish comments from Federal Reserve officials — preventing a deep, cathartic selloff of the kind we haven’t seen since 2011.

Greece and oil could provide the needed impetus.

The “cheap oil is good for stocks” meme is being replaced by a slow realization that while consumers are poised to benefit, lower prices are going to hammer the U.S. energy sector and drag on corporate earnings growth and investment spending. Also at risk is the U.S. high-yield bond sector, which has become more exposed to shale energy companies in recent years, as shown in the chart of the SPDR Barclays Capital High Yield Bond ETF (JNK).

jnk chart

With U.S. shale production only now starting to respond to the drop in prices — with drilling rig counts very slowly starting to fall — the weakness in crude oil looks set to continue. Options traders today noted activity in June 2015 crude puts with strikes of as low as $20 — suggesting that a floor has yet to be found for energy.

European stocks were hit hard in response to over-the-weekend chatter out of Germany that its leaders felt Europe was ready to let Greece leave the eurozone — something that has since been walked back a little. Another problem is that this situation slams the brakes on the expectation that the European Central Bank would launch a controversial, but long promised, government bond-buying stimulus program.

If there are doubts that Greece will honor its debt obligations, or fears that a Greek exit would immediately create problems for countries like Spain and Italy, it will be hard for the ECB to launch such a program. And that, in turn, would undermine many of the assumptions investors have made regarding the value of European stocks and bonds — with negative repercussions for financial markets globally.

In response, I continue to recommend investors prepare for further market losses and an increase in volatility. The VelocityShares Daily 2x VIX Short Term ETN (TVIX) I’ve recommended to Edge subscribers gained nearly 15% today and is up more than 27% since first recommended in early December.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters.

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