How Oil Prices Influence the Market

Based on the elevated level of volatility, there is a very high correlation between the direction of the major averages and that of oil prices. Only on a couple trading days of the past month has the market gained when oil prices have fallen. It’s counterintuitive that cheap energy prices would be bad for stock prices because the cost of energy is an important input to running a business, household or automobile. When cheap oil drives down the cost of fuel and anything associated with being petroleum-based, it would seem most logical that there is a vast positive cause and effect relationship at work. At present, there is monumental attention being given to the United States Oil Fund (USO) as it trades at levels not seen in 20 years.

However, market participants have construed that the decline in crude oil prices, along with that of all other commodity prices, has a twofold destructive message underlying the price declines. The first assumption is that there is a worldwide slowdown in gross domestic product (GDP) growth that is underway that is undermining all the coordinated central bank efforts to employ massive amounts of quantitative easing (QE) to stimulate the largest economies that drive global growth. The second is the overlying fear of a systemic contagion within the junk bond and non-rated debt market, where highly leveraged energy companies are at risk of widespread defaults.

So far, the big scare from the halting of redemptions at the Third Avenue Focused Credit Fund hasn’t sparked a full-blown panic, and expert traders within the junk bond market have expressed a tone of calm, saying the two largest junk debt exchange-traded funds (ETFs) that are a proxy for that market have traded in a very orderly manner. Shares of the SPDR Barclays High Yield Bond ETF (JNK) and iShares iBoxx $ High Yield Corporate Bond ETF (HYG) plumbed new six-year lows on the Third Avenue headline but have since stabilized even as the tape is painted with negative stories on the demise of oil prices.

The market is currently joined at the hip to these three tickers — USO, JNK and HYG. They will likely have a strong impact on how the year will end for the major averages. Widespread use of algorithmic trading platforms trigger “buy” and “sell” programs based on the daily price action of these three market components, and for the time being, investors should pay close attention to them as well. The Fed has done its thing, yet not much else has changed in the world other than more tax selling following an initial rally attempt.

Bond yields actually came down last week, and the benchmark 10-year Treasury is now trading below 2.20% against more macro data suggesting the U.S. manufacturing sector is contracting further. The Philadelphia Fed’s Manufacturing Index, better known as the Philly Fed, slipped back into negative territory in December with a reading of -5.9 versus 1.9 in November, the lowest reading in three years. A number below zero denotes contraction. This is the third negative reading in the diffusion index for current activity in the last four months and reflects weaker manufacturing conditions in the region.

In staying on point with the domestic thematic investing strategy, and assuming a slower growth rate for the global economy is going to weigh on the U.S. GDP growth rate, it’s my view that taking a position in the U.S. broader utility sector at a deep discount is a timely move. Consider what most Americans depend on: electric utilities, water utilities, cable television providers, data and wireless telecom services, cellphone tower operators, railroads and pipeline transmission companies. In a market beset by uncertainty, some things in your everyday life are quite certain, like using your iPhone.

America’s largest telecommunications company, AT&T (T), has a dividend yield of 5.6%. It recently closed on the acquisition of satellite television provider DirecTV. As of the end of the third quarter, the company served 120 million wireless customers and just became the largest pay-television provider in the United States and the world. The DirecTV acquisition significantly diversifies AT&T’s revenue mix, products, geographies and customer bases, as do AT&T’s acquisitions of Iusacell and Nextel Mexico.

AT&T expects that, by the end of 2015, its largest revenue streams will be, in descending order: Business Solutions (both wireless and wireline); Entertainment & Internet; Consumer Mobility; and International Mobility and Video. And all of this progress is independent of the Fed and the price of oil. Wall Street is forecasting earnings of $2.82 per share next year on a 14.3% increase in top-line revenue to $170 billion. The company has beaten earnings estimates for four straight quarters and another outperformance for Q4 should set the stock in motion to challenge the 2013 high of $39, my 12-month price target.

In case you missed it, I encourage you to read my e-letter column from last week about using covered calls to generate income. I also invite you to comment in the space provided below my commentary.