We are at a very crucial point in the market. People are focused on the Federal Reserve Board meeting on 12/6/15 and most believe that a rate hike or back to normalization would take next week. Up to last week, the reaction from the market was very minimal. I am a contrarian but even I failed to be true to myself last week. As I mentioned in my first December issue, I predicted that we would have a Santa Claus rally by the latter part of the December. Usually in December, during the first part, the market goes down due to tax selling and then bargain hunters come in for the rally. It could still happen. I ignored a few things (1) When most expect something, the reverse happens (2) The market was making lower highs and lower lows. In other words, every time the market rallied, it hit a high that was lower than the previous high and when the market went down, the bottom it reached was lower than the previous low (3) A technical analyst who came on CNBC around 12/9/15 stated that the probability of a severe downturn in the market is quite probable. For the past 4 years I have been asking everyone to keep 50% of the portfolio in cash and I suggest that you keep doing that; most probably till 2018. The best thing to do, is like I do, to have some out of the money put options on a market index as a hedge. Very soon, my book on Basic Options Trading would be available on Amazon. When the DJIA (Dow30) fell 1,180 point on 8/20/15 and 8/21(Friday), in my newsletter on 8/23/15, I mentioned that we could have a severe correction very soon and on Monday 8/24/15, during the first 5 minutes the DJIA (Dow30) fell 1100 more points. There is a very good possibility that we could face another severe correction next week for the reasons listed below:
· For the first time since late September 2015, the VIX index rose over 25. The VIX index measures market expected volatility for the next 30 days. VIX index rose from 13 to 40 on 8/24/15 (highest since it was invented around 1991). Most of the VIX Call options expiring 12/16/15 rose 200% to 600% in one day. However this also means that we could be close to a short term bottom. If that happens, sell some of the stocks you do not want to wait a long time to profit from and better yet buy some put options on the major indexes (i.e. S&P 500 in SPY,DJIA in DIA or the NASDAQ in QQQ).
· For the past 6 months I have been saying that the high yield bond market is highly illiquid and ready for a crash. There are over $3 Trillion high yield bonds that will mature in 2016 to 2018 and they cannot bring more such bonds in to the market as they cannot find buyers for such bonds. When people cannot sell what they want to sell, they sell what they can. This is why the contagion from the high yield bond market is going to impact all markets. As I mentioned a few weeks ago, the Managing Director of the IMF stated that the next financial crisis will start with the corporate bond market. On Friday 12/11/15 we saw the first visible signs of it when the Third Avenue Junk Bond Fund (bonds were not even rated!) stopped redemptions and they did that prior to informing the SEC. CNBC reported that Stone Hedge Fund did the same. Carl Icahn who came on CNBC stated that this is just the beginning. Also Jim Cramer reported that all day 12/11/15 mutual funds were asking clients to withdraw funds from high yield bond funds. THIS IS GOING TO BR HUGE! Even the 1987 stock market crash took place due to the contagion effect from the bond market. If this does not happen within the next month, it will happen within the next 2 years so always keep 50% in cash. If the ETFs start going insolvent as some predict, then we will see a 50% to 90% decline in equities. This is a totally new experience as we have never had ETF controlling a good portion of the financial market.
· Historically after the first rate hike, you see a lot of market volatility. Usually prior to Fed meeting, the market moves up but we did not see this yet and that too is a bad sign.
· One of the main reasons for the market downturn was the price of oil (WTI) which dropped below $36. Of all high yield bond issuers, 40% are in the oil patch. In a panic, when the whole market goes down, even the solid companies go down. We are 100% sure to see many oil companies go insolvent in 2016. For now, oil majors like Exxon Mobil, Chevron and so on are okay but if we have oil (WTI) below $40 for one year, we will have to take a second look at that.
· Options Triple Witching hour falls on 12/18/15. An event that occurs when the contracts for stock index futures, stock index options and stock options all expire on the same day. Triple witching days happen four times a year on the third Friday of March, June, September and December. This usually causes a lot of volatility in the stock market.
When all the traders are on one side of the trade, there is a good possibility that the market would move the other way. On Friday, Simon Hobbs (CNBC financial host) was talking about the rise of the Euro against the dollar during the past few days and said, “When everyone says something is going to happen, close your ears. The opposite might happen”. That is the contrarian viewpoint. So this means that we could experience a short term bounce in the market in the near future and that would be a blessing as we would be able to sell some profitable trades and buy some more hedges. If the Feds move the rates higher next week, volatility would be here for a long time but volatility is not a bad thing as we get opportunities to make investments for the long term.
Even though almost all analysts expect the Feds to raise rates next week (12/16-12/18), I believe that depends on what happens in global markets between now and then. I won’t be surprised if the IMF Managing Director is trying best to persuade the Feds not to raise rates now as to avoid a global economic meltdown. Sooner or later the Feds have to normalize rates and go over 0% as we are close to full employment and that will not come without any pain. Longer they wait to raise rates, more pain there would be. Initially around 2008, they had to take rates down to 0 and have the quantitative easing to avoid the economy going in to a great depression. Bernanke saved the US and the world! Due to their intervention, the unemployment rate went from 10% to 5% in 6 years. According to Barron’s, in 2009, for every job opening, there were 6.8 unemployed (15 year old high); and in 2014, it was 1.9 and now it is at 1.9.
Most of the bond market woes come from the commodity market; especially the oil market. In the oil market, the major integrated companies are safe for now. If WTI (oil price) remains under $40 for 12 months, even those companies could cut dividends and face the wrath of investors. On 12/8/15, Chevron CEO was interviewed by a CNBC anchor and these are the highlights (these are valid for Exxon Mobil too):
· His # 1 priority is pay and increase the dividend. They have been increasing the dividend for the past 28 years..
· Whatever the price of oil, they know how to run a profitable operation.
· Now even cutting the labor force, he is reluctant because he sees an upswing in the industry.
· Long term projects are currently on hold.
· Smaller companies are too expensive now; and those companies have managed to cut costs and yet increase production.
· For decades Saudi Arabia had excess capacity as they were fearful that the price of oil might go too high and lead to a decline in demand. Now that concern is no longer valid so they do not see a reason to cut production.
· Smaller companies are busy keeping creditors happy so they are not in a position to focus on running the business.
Former BP Chairman was on Bloomberg and he stated that all big integrated oil companies only produce in low cost environments and they are always prepared for all eventualities. He also stated that except for the past decade, the average price of oil (WTI) has been quite low. In fact I did a fact check and I found that between 1/1/1986 and 12/7/2015, the average price of WTI was at $42.87. However on 12/11/15, WTI price went below $36 and Godman Sachs believe that price could drop to $25. If that happens, companies like Exxon Mobil and Chevron would be a good place for you to invest your money for the long term. It is just a ‘no brainer’!
To sum it up; be prepared for wild fireworks (up and down) on Wall Street for next week; 12/14/15 through 12/18/15 as well as for the next month or two. As of Saturday, December 12, 2015, the futures market shows that the DJIA (Dow30) will open with a 300+ point decline. There is a lot of time between now and Monday morning so it could go either way by then. On a given day, as it happened on 8/24/15, if the market goes down heavily and end the day on a very positive note, that could spell a short term bottom for the market. For example, the market could go down 1,000 points (-1,000) during the day but end the day with +200 (1,200move from the bottom to the top). If you are concerned that the market would fall more than 25% within the next 6 months, with 3% of your portfolio, you might want to buy put options on DIA (ETF for the DJIA or Dow30) that expire 3/18/16 with the strike price 160 (equal to the Dow at 16,000). Current option price is $355 per contract or 100 shares.
Put on your seat belt, hold on to your seat and have a nice roller coaster ride next week!