The Latest Worry About Oil Is...

For a while on Monday morning, it began to feel like the Holidays had started early. While stocks had opened down on some new weak data in Europe, the indices recovered relatively quickly. No, make that almost instantaneously, as the opening down draft lasted a total of two minutes. And after the requisite rebound, things got fairly quiet for a couple of hours. Then it happened. Out of the blue and on absolutely no discernible news, the S&P 500 dove eight points in eight minutes. But, there was no explanation for the sudden dive picture below. In short, the chart shows sell algorithms in action. This is what happens during the day when you are in a meeting, on the phone, or at lunch. Regardless of how quiet things are, there is always a computer-driven trade ready to be dropped. And on a day when there were already "technical difficulties" in the market, the 6100 eMini's that were sold in one second at 12:20:05 (hat tip to Eric Scott Hunsader of Nanex) were simply too much for the market to handle. This "out of the blue" action is represented by the first red box in the chart below.

S&P 500 SPY - 1-Minute

The game of "Dump the eMinis" continued about an hour later. But this time around there were some "excuses" associated with the selling - namely the ongoing dive in oil and what was turning into a pretty intense smack-down in the social media names. The second red box shows another 13 S&P points coming off the index as the waves of selling just kept on coming on no news. So, this is what happens when the boys and their high-powered computer toys try to get ahead of the game. Or in this case, it may have been more a case of traders knowing that buyers would be standing aside. With the market having run a very long way in a very short period of time, sellers likely knew that they probably had a free pass for a while. So, with buyers fidgeting on the sidelines with their hands in their pockets, the action depicted in the second red box tends to occur.

The Oil Argument

To hear traders tell it, Monday's intraday dive was tied to oil breaking down to fresh new lows. Apparently oil fell to levels not seen since February 2009 on nothing new, just more selling. But while consumers may be rejoicing, folks in the bear camp tell us that the ongoing decline in oil is bad - perhaps even very bad. First there is the argument that falling oil prices will kill the shale/fracking boom and all the job growth that goes along with it. As the thinking goes, lower prices will cause the highly levered/marginal players to go belly up. In turn, this will lead to defaults on junk bonds. Perhaps even a lot of defaults in junk bonds.

US Oil Fund USO - Daily

Why should investors in the stock market care? Well, here's the rub. Those defaults will eventually come home to roost in the banking system. And as everyone learned in 2008, anything that threatens the banking system is a problem. All those investors who didn't manage risk very well in '08 have since made it their life's work to never get fooled like that again. And as such, everyone and their uncle is looking for the next thing that could damage the banking system. Frankly, the idea of oil companies in North Dakota bringing down the banking system seems like a monumental stretch. But there are a couple other worries on this topic worth noting.

Falling Oil Is NOT Good For Emerging Markets

The decline in oil prices means less revenues to all oil producing countries. But unlike Saudi Arabia, not all oil producers are in a state of strong fiscal health. And in places like Iraq and Syria, falling prices will hurt their ability to fight ISIS. Thus, the next logical progression is that if prices continue to fall, so too might some governments. This, of course, could lead to more unrest in the Middle East. Then there is the financial ramifications to the oil producing countries. While places like Qatar and Kuwait have plenty of cash on hand and don't need high oil prices in order to keep the country's finances in order, an analysis of the fiscal break-even oil price relative to a country's debt is very interesting. According to a study done by MEES, IMF and Citi Research, Saudi Arabia needs oil at $103 in order to balance their budget in 2015. Russia needs $107. Oman requires $103. So, $60 might be a problem for these countries, right? But here is where it gets interesting/scary. Libya needs oil at $184 to balance their budget. Venezuela is at $151 and Iran needs $131. Therefore, $60 is likely a VERY big problem here! Therefore, the thinking is that either oil prices will find a way to move back up or many of these countries will fall on hard times. And what happens when these countries fall on hard times? Oh, that's right, they start to default on their sovereign debt. And what happens to the financial markets when countries start to default? The short answer is, nothing good. So, while many view falling oil as the next great thing for the U.S. economy, the fear is that the resulting fallout around the globe might not be so positive. Therefore, it might be best to steer clear of junk bonds, emerging markets equities and emerging market bonds for a while until things settle down.