Will You Hear The Screams?

34185387_sJill and our kids think it is a bit strange when I talk to my car, golf clubs, et cetera, like they understand me. I explain to them that the idea that cars, sports equipment, et cetera, can “talk” is a guy thing.
Come to think of it, I can’t remember seeing a woman talk to a golf ball before she teed off, and yet I know plenty of guys who do this, even before they start drinking! Guys will ever so calmly (said sarcastically) discuss life with their car if it refuses to start. Even in that statement I used “refused,” as if the car was making a choice not to start.
We do the same thing when it comes to the markets. We talk about them making fools of everyone or not giving anyone a clear indication of what is coming next. We treat them as if they have an unpredictable mind of their own.
That’s all nonsense of course, except when it comes to the bond markets, specifically the high-yield bond markets. In this instance, I’m sure there’s something to the notion of a talking market, and recently the high-yield bond market has not been whispering quietly; it’s been screaming.
Do you know that there has only been one other time in history when the price of oil has crashed by more than 40 bucks in less than a half a year? The last time oil crashed, like it has recently, was in the second half of 2008, and we all know what followed.
Historically, when oil prices have dropped, an economic slowdown has followed. Energy companies account for about 18 percent of the junk bond market. So it makes sense that movement in the value of junk bonds is an indicator of market stability . . . good or bad.
So let’s take a look at what is going on with the energy sector of our economy. Is it quietly warning us of another financial collapse? Or has it already started screaming?
The United States is currently out-producing historical oil giants like Saudi Arabia and Russia. The fracking revolution has elicited a boom for shale oil-rich regions here in the US. There is no denying that the shale oil boom has had a significant impact on our economy. It has created millions of jobs and, in my opinion, has been one of the largest contributors to a shrinking unemployment rate. In fact, the increase in domestic crude oil production has propelled it to multi-year highs. According to estimates from the US Energy Information Administration, US crude oil output for the week ended December 5 increased to 9.1 million barrels a day, its highest level since 1983.
But all of this could be coming to a crashing halt. Let me explain why. In essence, OPEC has declared a price war on the US oil producers and this is not good. You see, it costs less to extract oil from places like the Middle East than to extract from places like Texas and North Dakota. If the price of oil stays on its downward trajectory, US businesses could fold and jobs could be lost. OPEC knows this and they are ruthless when it comes to protecting their market share.
Since the last Great Recession in 2008, the energy sector has been one of the largest growth sectors of our economy. So if prices keep collapsing, domestic energy companies will not be profitable since they will not be able to cover the cost of production in the United States. The energy sector is responsible for creating jobs and so if this sector slows significantly, well, this could be quite detrimental to our economy.
Are you hearing the screams yet? Will history repeat itself? Could we have another significant market correction?
Here is the rub. If about 18 percent of the high-yield bond market is tied up in the energy sector, what happens if those companies go out of business? They default on their debt, thereby triggering a depressed high-yield bond market, the effects of which will ultimately hit our equity markets.
The first to get hit financially are usually the banks, which is what happened in the last Great Recession with the housing crisis.
Consider what Barclays wrote in a recent article, “High yield does provide useful sell signals to equity investors.” In June of 2007, two Bear Sterns hedge funds were some of the first to signal massive losses in the subprime mortgage mess. Despite the screaming of the high-yield bond market, the S&P hit all-time highs by October of 2007. And then we all know what followed, almost 18 months of losses that so many suffered. Hmmm . . . Don’t you wish you had listened to the screams then?
Barclays went on to say, “…equity investors should ‘position defensively’ the next time junk bonds start to go haywire. That doesn’t necessarily mean dumping stocks altogether.”
My message to you, Cutter Family Finance readers is this: as we enter into 2015 keep your eyes on the junk bond market and big banks. Now may not be the time to be taking on more risk. If you do not have a tactical “risk off” investment strategy securely in your retirement system, well, why not?
History has proven that when high-yield bonds collapse, a major market downturn is the next to come.
Heck, at least this time you heard the scream.
Be vigilant and stay alert, because you deserve more.
1. http://tinyurl.com/o2zfm3z, 2. http://tinyurl.com/mexdffn, 3. http://tinyurl.com/kcwsm9b, 4. http://tinyurl.com/kcwsm9b