By Pete Biebel, Senior Vice President

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When the S&P 500 Index (SPX) survived a test of its 2600 level last Monday, it was looking like it would be a nice week for the market.  Coming out of an oversold condition with the big reversal that Monday, the Santa rally was cleared for takeoff.  The averages all traded above their Monday highs on Tuesday and above their Tuesday highs on Wednesday.  Unfortunately, the rallies didn’t stick.  On each of those days, the afternoons were not so nice; prices slumped into the closing bell and the averages finished well off their highs.  The market’s naughty habit of squandering easy, early gains left the promise of a rebound in doubt.  The Santa rally sleigh barely got off the ground.

The lack of early-week niceness enabled and encouraged the late-week naughtiness.  The averages failed to get above their Wednesday highs on Thursday, and ended that day mixed to lower.  Friday morning brought a gap-down opening largely in reaction to news that the Chinese economy was slowing more rapidly than expected.  That bit of mischief got down-right nasty as the averages headed lower through the day with barely a hint at an intraday rebound.  The major averages all lost about 2% on Friday, dropping their net performance for the week to losses of about 1%.

In recent articles, I’ve emphasized the significance of the 2600 level on SPX.  The fact that SPX popped all the way back up into the 2640s on Monday afternoon after poking below 2600 (for about a half-hour) that morning, had visions of sugar plums dancing in the heads of the bulls.  By midday Wednesday, SPX had climbed to just over 2680, but that proved to be the high of the week.  By the end of the session Thursday, that index had slumped to about 2650; Friday’s assault left SPX teetering on the brink at 2599.95.  You can’t make this stuff up.

The Financials sector was the big loser last week, down about 3 ½% over the past five days and down more than 10% over the past five weeks.  Several big bank stocks had losses of 5% to 8% for the week; several medium-size bank stocks had losses of 7% to 10%.  Along with the Energy and Industrials sectors, the Financials sector fell to its lowest level in more than a year.  The flattening interest rate yield-curve has gotten a lot of blame for the woes in bank stocks, but another factor is responsible for much of the most recent wave of weakness: The meltdown in the leveraged loan market.

As has been the case recently in the high-yield or “junk” bond market, prices for existing bank loans, especially riskier leveraged loans, have been dropping sharply.  These are typically floating-rate loans, which are less negatively correlated to changes in longer-term interest rates.  So, it is the fear of declining credit quality that is causing the deterioration in the value of such loans.  And, that weakness has gotten to the point where it’s feeding upon itself.  One of the leading leverage loan funds saw record outflows last week.  Lipper Analytical Services, a subsidiary of Thomson Reuters, reported that U.S. loan funds had $2.5 billion in outflows last week; that was an all-time record, exceeding the recent record by nearly 50%.  Those redemptions forced more selling of the underlying loans.

If that trend continues, it won’t be a nice thing for the stock market, and it looks as though things are going to get worse before they get better.  Several new loans and re-financings were canceled last week as the indicated rates on those loans spiked higher.  One major bank, in order to spur demand on a $210 million loan to a private jet company, had to slash the price to 93 cents on the dollar.

Energy was the second-worst of the U.S. equity sectors last week.  The S&P Energy Sector Index mirrored the decline in Financials, dropping just over 3% in the past five days and a little more than 9% in the past five weeks.  Hopes for a rebound in Crude Oil prices went unfulfilled.  Crude tanked from about $76 per barrel in early-October to near $50 in late-November.  That price has been mired in the low-$50s for the past several weeks.

The Healthcare sector, along with Consumer Discretionary and Technology, was one of the three sectors that led the market higher through the summer.  When the other two broke down and dropped below their 200-day moving averages in October, Healthcare held at its 200-day.  The sector even recorded a new closing high on the November rebound rally.  But, its wellness may now be in doubt; losses over the last two weeks dropped the sector to its lowest closing level since October.

Quality dividend paying stocks and low-volatility defensive names have become a refuge for investors fleeing the volatility of high-beta issues.  The Utilities sector gained about 0.6% last week and has now climbed about 3 ½% over the past five weeks.  It edged out its November 2017 high for a new record level.  That sector leap-frogged over the declining Healthcare sector to become the U.S. equity sector with the best year-to-date performance (+7.92%).  Although it had a loss last week, Real Estate is the only other U.S. equity sector that has had a positive return over the past five weeks.  In the prior week, that sector reached its highest level in 2 ½ years.

The FOMC is expected to hike its short-term lending rate at this week’s meeting.  The real news from that meeting will be guidance on the Committee’s expectations for future rate increases.  In its most recent monthly economic outlook, the research firm Zacks projected just two rate hikes in 2019 and no more than three total rate hikes through 2019 and 2020.

Friday’s SPX close within pennies of 2600 left us hanging is suspense.  A replay of last Monday’s brief poke below the 2600 level wouldn’t be a surprise.  An immediate rebound from such a dip would likely rekindle hope for a rally through the holidays, but that seems to be only about a 10% probability.  On the other hand, as we’ve cautioned in recent weeks, sustained trading below 2600 would signal that a potential test of the February/April lows was back in play.  As I write this on Sunday evening, the stock index futures are trading about 0.4% higher.  If the market can hold those gains through the day on Monday, then the prospects for a 2% to 3% rally into the Christmas holiday would remain about a 40% probability.

Earnings season has about run its course; this week will bring only about a dozen new reports.  Still, it might be fun to watch the market’s reaction to the announcements particularly because several of the reporting companies have had their stock prices beaten down to multi-year lows by recent market action.  Reaction to the FOMC meeting announcement will likely spur another bout of volatility just after 2:00 PM EST on Wednesday.  While the market hasn’t shown much reaction to the prospects of federal government shutdowns in the past, the market will be watching the rhetoric from our leaders this week.  The threat of a shutdown of more than a day or two could be interpreted as another naughty factor in the markets.

Date Report Previous Consensus
Monday 12/17/2018 Empire State Manufacturing Survey 23.3 21.0
Housing Market Index 60 61
Tuesday 12/18/2018 Housing Starts 1.228mm 1.222mm
Wednesday 12/19/2018 Existing Home Sales, SAAR 5.220mm 5.190mm
FOMC Meeting Announcement, Forecasts and Press Conference
Thursday 12/20/2018 Initial Jobless Claim  206K       221K
Philadelphia Fed Business Outlook Survey 12.9  17.5
Friday 12/21/2018 Durable Goods Orders, M/M -4.4%  +1.5%
Durable Goods Orders, ex-Transportation, M/M +0.1%  +0.3%
GDP, Q/Q, SAAR +3.5%  +3.5%
Personal Income & Outlays, Income, M/M +0.5%  +0.3%
Personal Income & Outlays, Spending, M/M +0.6% +0.3%
Consumer Sentiment 97.5 97.5
“Quadruple Witching” Expiration for options and futures

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