In July, Investors Were Guests at the Market’s “Red Wedding”

The simultaneous blood baths in commodities and U.S. stocks continued in July but failed to penetrate the skulls of U.S. stock investors who continue to allow themselves to be brainwashed into believing that they can only make money by owning an overbought market.

The S&P 500 (INDEXSP:.INX) recovered all of its June losses, gaining 2.1% in July including 1.2% last week to close the month at 2103.92, not far off its record closing high of 2,134.72. The index is now up 2.2% (excluding dividends) for the year.

The Dow Jones Industrial Average (INDEXDJX:.DJI) is showing greater recognition of the troubled state of the world. And after last week’s 0.7% gain to 17,689.86, it is down -0.7% year-to-date.

The Nasdaq Composite Index (INDEXNASDAQ:.IXIC), powered by stocks such as Amazon.com Inc. (NASDAQ: AMZN), Facebook Inc. (NASDAQ:FB), Netflix, Inc. (NASDAQ:NFLX) and other biotech and social media names, is outpacing the other indices with a year-to-date gain of +7.6% after adding 0.8% last week to close at 5128.28.

At this point, investors can no longer ignore the fact that the knives are coming out…

The Weakness Under the Surface Is Obvious Now

The entire stock market, however, is seeing narrowing breadth and is vulnerable to a correction when those large capitalization technology, social media and biotech stocks stop sucking all the air out of the room.

The strength of the indices is disguising serious weakness under the surface. Anything commodity related has been decimated.

After announcing earnings on Friday, ExxonMobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) shares are down 21.1% and 31.7%, respectively, over the last year. The Energy Select Sector SPDR (ETF) (NYSEArca:XLE) is down 29.8% over the same period.

Commodity hedge funds are getting wiped out, including one fund owned by private equity giant Carlyle Group LP that saw its assets drop from $2 billion to $50 million as a result of losses and client withdrawals. A number of other funds have been forced to close shop after suffering massive losses.

The problem with the commodity space is that the prospects for recovery are dim in view of the likelihood that the U.S. dollar is going to continue to strengthen and China’s economy is going to continue to weaken.

Commodities are priced in dollars, so dollar strength hurts demand, while China has been the marginal buyer not only of oil but of virtually every other major commodity such as iron ore, aluminum and copper since the financial crisis. Commodities have sailed into a perfect storm and are taking a lot of ships down to the bottom of their sea.

That’s not the only place investors are getting “killed”…

A Dark Fantasy Story Becomes Market Reality

Another market that has been shattered by the commodity sell-off is the junk bond market. July was like the infamous, gory “Red Wedding” in Game of Thrones for investors in energy and industrial junk bonds.

While the overall junk bond market saw spreads widen by 38 basis points and average yields near 7% for the first time in a long while, energy bond spreads engorged by 208 basis points and average yields swelled to 10.7% while basic industry bond spreads swelled by over 100 basis points and average yields ended the month at 9.4%.

For those unfamiliar with the bond market, such moves are only seen when the market is totally melting down and mean that bond prices are dropping by 10-20 points, leaving bloody corpses strewn all over the place.

Several fracking companies gave up the ghost and filed for bankruptcy and many more will follow because oil prices are almost certain to test their early 2015 lows. The real danger is that the rising dollar could push oil into the $30s and keep it there for longer than virtually anybody is forecasting, flushing more leveraged energy and commodity companies into bankruptcy court.

And then there’s China.

You Would Want to Sell, Too

China’s Shanghai Stock Exchange Composite Index lost 14% in July despite the efforts of Chinese authorities to stop the selling. China’s markets remain in a freefall that would be far worse… if they were allowed to operate like real markets.

In fact, every time investors were allowed to sell that’s exactly what they did. China’s authorities have destroyed any credibility they had with respect to their markets and it is going to take a long time to get it back even in this gullible world of ours.

The bigger question is what China’s leaders can do to prop up an economy that suffers from massive overcapacity in all the export and real estate sectors and a debt overhang of at least $28 trillion in its banking and shadow banking system.

China is headed for a financial crisis with the only questions being when it will occur, how it will deal with it, and how severely a crisis hitting the global economy’s primary post-crisis engine of growth will affect the rest of the world.

Investors may not want to contemplate these questions as they hug their 401(k) statements at night and tell themselves how brilliant they are for owning stocks like Apple, Inc. (NASDAQ:AAPL)… and Amazon… and Facebook… and Netflix… but that bubble will burst as well – like all bubbles will.

When the price of oil – the most important commodity in the world – drops by more than 50% in a period of six months, it is sending a signal about the health of the global economy.

Anyone who believes they don’t need to listen to that signal will regret it.

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