The Main Risk Heading Into the Fed Meeting

The overwhelming focus of Tuesday’s session was once again the free-fall in oil prices. After crude dipped below the $37-per-barrel mark to the lowest level in seven years early in the trading day, a quick rebound resulted in the commodity closing nearly flat.

The trend for oil remains lower, but signs increasingly point to a potential short squeeze.

Stocks traded in a choppy and range-bound fashion, much like they have been since last week’s European Central Bank meeting and better-than-expected November jobs report.

My main question heading into today’s trading is whether equities will just shuffle sideways right into the Fed’s statement following the Dec. 16-17 FOMC meeting. That is certainly a risk, in which case I don’t want to get chopped around in a directionless and low implied volatility tape. So patience will likely be required until the Fed potentially releases the Kraken in the form of a 25-basis-point rate hike.

On that note, after close to 20 years as a trader, I have learned that the “one thing” investors are concerned about at any given point tends to not move the market as much as anticipated because all the worrying has essentially priced it into the market.

From a seasonal perspective, U.S. stocks tend to see some weakness into the middle part of December before the traditional year-end rally begins, as you can see in the chart below based on 30 years of price data from the S&P 500. So far this month, this seasonal pattern has held.

S&P 500 Seasonal Chart


Therefore, at the current juncture, I am wondering two things:

  1. Will we see seasonal patterns play out once again for equities in the second half of December?
  2. Will potential weakness in the dollar lead to a big short squeeze in oil and the broader commodity complex?

The fact that the toggle point for a year-end rally coincides with the possibility for the first rate hike in nine years means the Fed is likely to determine whether the market will be visited by a Santa Claus rally this year.

In terms of oil, the longer-term chart shows prices getting incrementally closer to a retest of the late-2008/early 2009 lows in the low $30s.

Oil Chart
Click to Enlarge

For active investors, this area can be used as a pivot point. Any strong reversal may see a squeeze higher into the first quarter of next year.

While a real bottoming phase may take longer to complete, signs that we are nearing at least a temporary low include hedge funds taking extremely bearish positions, a positive divergence between price (lower lows) and momentum (higher lows), and companies like Kinder Morgan Inc (KMI) cutting dividends.

To be clear, price is the ultimate arbiter and the only way investors get paid. So until we see a clear washout in the price of oil followed by a strong bullish reversal, it is too early to get long oil and oil-related stocks.

Looking at Energy Select Sector SPDR (ETF) (XLE), the recent sell-off has taken the fund back to a longer-term support zone. This area has plenty of price history from 2009 to 2011. A strong bullish reversal in this area may well help support the energy sector into the first quarter of 2016.

XLE Chart
Click to Enlarge

As far as the broader stock market is concerned, market breadth continues to be weak and, thus, something to be increasingly concerned about as we head into the new year.

At the bottom of the S&P 500 chart in blue is the ratio of the equal weight S&P 500 divided to the regular S&P 500.

S&P 500 Chart
Click to Enlarge

What the falling line tells us is that the S&P 500 is being held up by a few heavily weighted stocks and the rest of the index is underperforming by a wide margin.

Into year end, however, performance chasing on the part of fund managers is likely to win out. Barring any big surprise from the Fed, the S&P 500 still looks to have upside potential toward 2,170. Active investors could buy a strong bullish reversal after a dip or a break and hold above the 2,100 area.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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