Making Sense Of The Oil & Stock Linkage

If an investor's response to Wednesday's trash job in the stock market was something along the lines of, "Wait, what?," they are likely not alone.

On Tuesday, the stock market dove 220 points early on and then recovered almost all of it into the close. Thus, it looked like the dip buyers appeared to be back with a vengeance. But then the very next day, the Dow dove 268 points and the dip buyers were nowhere to be found.

So, what gives?

While it may sound a little silly, the U.S. stock market is now trading almost in lock step with the price of oil. Look at a one minute chart of the US Oil ETF USO and compare it to the S&P 500. Looks remarkably similar, right? Now compare the result of the S&P to the USO over the last three to four days. What you'll find is that when oil goes down, stocks go down - and vice versa.

Yep, it's that simple right now.

Granted, this is a very new development as the correlation between oil and stocks has only been in effect for a few days. But this would seem to explain the schizophrenic behavior seen in the stock market lately. The game isn't about the will-they or won't-they situation regarding QE in Europe. It isn't about China's stimulus, Japan's economy, the holiday shopping season, the Fed or even earnings. No, it's about the crash in oil!

Related Link: Are The Oil Worries For Real?

And in short, understanding how the computers are playing the game right now may also help you from pulling your hair out.

Why The Linkage?

The logical question, of course, is why are stocks and oil joined at the hip right now? Oil has been crashing for nearly six months now but the stock market is only now starting to notice.

US Oil Fund USO - Weekly

To be sure, the weekly chart of the USO is ugly. Now compare that to the chart of the S&P 500 over the exact same time period and it is fairly safe to say that oil's debacle has not been much of a problem for the stock market. So again, why the sudden linkage?

S&P 500 - Weekly

However, there is another pair of charts that makes the situation a bit clearer. First, take a peek at a daily chart of the USO. But fair warning, those with squeamish stomachs may want to avert their eyes.

US Oil Fund USO - Daily

Now peruse the chart below. This is a daily graph of the SPDR High Yield Bond ETF JNK. While the charts are definitely not identical, it is fairly clear that the junk bond market has started to notice the big decline in oil.

SPDR High Yield Bond ETF JNK - Daily

The reason here is simple. You see, something on the order of 25 percent of all junk bond issuances over the past few years have been for companies in the oil business. More specifically, the shale/fracking business.

So, as the price of oil plunges, the default risk for these companies rises - dramatically so. Especially for those companies that are highly leveraged. Therefore, the junk bond market is pricing in the ever-increasing risk of companies defaulting on their bonds.

But frankly, why should the S&P 500 care if a few oil firms go belly up in North Dakota?

Lessons From the Credit Crisis

Lest we forget, one of the key components of the market meltdown of 2008 and early 2009 was that credit dried up - almost completely. Remember, even GE couldn't float commercial paper at that time. Nobody was willing to lend money to anybody else. The credit market has seized.

Related Link: The Latest Worry About Oil Is...

These energy companies at risk of default due to the dive in crude have lines of credit that they think they can use. However, if things get worse here, banks will likely cut those lines. This will speed up defaults. And the worry is that a credit contagion will follow. Suddenly truckers and railroads are at risk.

Just yesterday, there was word that the mess in the bonds of the energy sector is starting to spill over into the chemicals sector. And if this continues to spread, well, you get the idea.

The bottom line is this... Nobody wants to even think about what might happen if the credit markets freeze up again. As such, it appears that a case of sell first and ask questions later may be developing.

What Are Investors To Do?

The decision facing stock market investors at this stage appears to be fairly straightforward. If you believe that oil is going to continue to fall AND that the decline will create more havoc in the junk bond market AND that the ensuing problems in junk will spread to the banks, and then eventually cause liquidity problems in the banking system, then by all means, head to the sidelines.

If the contagion argument is a stretch, then any further declines in the stock market may present a buying opportunity.

So, good luck to everyone and as they used to say on Hill Street Blues, "Let's be careful out there."