Market Perspective for December 15, 2014

Oil prices have now dominated the financial news for three straight weeks. OPEC oil production currently exceeds forecast demand in 2015 and the cartel has decided against production cuts at its most recent meeting. This decision prompted a steep drop in oil prices. Iran says oil could fall to $40 if OPEC doesn’t work together and called the current situation “treachery.” Over the weekend, a United Arab Emirates oil minister indicated the country won’t cut production until oil hits $40. In the U.S., oil shale production is starting to slide, but the big impact is in the high-yield debt market. Many shale producers took advantage of low interest rates, but the drop in prices imperils their ability to service their debt.

From a technical standpoint, the bears are in control of the oil market. A quick drop to $40 or even a test of the 2008 lows of $35 is possible due to financial factors. There are effectively two markets for oil: the real market of oil producers and consumers and the financial market. The real market is probably close to a bottom based on current economic data. The financial market can be driven lower by selling from speculators, such as hedge funds who have bet on oil prices going up. The drop in oil has accelerated in recent days because bulls are panicking. Peak panic usually occurs at the bottom.

The Federal Reserve could upstage the oil market this week. When the Fed issues its policy statement on Wednesday, it could change the language regarding its low interest rate policy. For many meetings, the Federal Reserve has said low interest rates would continue for a “considerable time,” but the strengthening economy has some investors wondering if the Fed will alter this wording and signal that rate hikes are coming in 2015. If the Fed were to make this change, it would be bullish for the financial sector, which does better when rates are moving higher.

A key data point out this week is the November consumer price index (CPI). The number is forecast to drop, partially due to falling oil prices. A lower inflation rate allows the Federal Reserve to delay raising interest rates, while a higher inflation rate would put pressure on the Fed to raise rates earlier than expected.

We will also see the flash December PMI numbers for China. China’s manufacturing sector is right on the line between expansion and contraction. Greece will hold the first round of its presidential election on December 17. The ruling coalition is expected to fail in this round (as well as round two), but the election will be closely watched to see how many votes the coalition picks up. It’s estimated they need to find 7 votes to secure victory in round three, when the threshold for victory drops from 200 votes to 180 votes. If the ruling coalition can’t pick up votes, it could put even more pressure on the euro.

Earnings are light this week with the most significant reports coming from Oracle (ORCL) and FedEx (FDX). FedEx’s earnings are closely watched as a gauge of the overall economy.

Stocks are slightly off their highs for the year coming into the week as losses in oil weighed heavily on the S&P 500 Index and Dow Jones Industrial Average. Even though oil prices have been falling since July, the broader indexes marched to new highs. As long as oil doesn’t repeat the drop from last week, the indexes should be in good shape thanks to strength in technology and healthcare. The Fed may tip the balance, depending on if its policy statement is favorable towards financials or not.

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