After a long period of the stock market thinking that lower oil prices are a good thing (for all sectors except Energy), the market now appears to have adopted the opposite view.
Over the past short while, when the spot price, a mere shadow of its June 2014 self, moves down, so too does the S&P 500. Economically sensitive stocks get clunked more than the average equity. And vice versa.
To me, this seems so obviously wrong …and yet it’s happening.
This wouldn’t be the first time that the market got a crazy idea into its head and ran with it for a while. Remember in 2009 when a number of prominent hedge fund managers proclaimed that the Fed’s decision to lower interest rates would quickly cause runaway inflation and that the only protection against this government folly was to stockpile gold?
Here we are six years later, with still no inflation to speak of. Gold had an amazing two-year run, which had nothing to do with the Fed, and everything to do with demand for the yellow metal in India and China. The gold price has since lost 40% of its value as new mine supplies have come into the market and as domestic developments in Indian and China have lessened their ardor for money-like stuff they can bury in the backyard.
It’s tempting to think that the reversal of view about oil is only occurring because most big market participants have closed their books for the year and are drinking egg nog on the sidelines. But I think it’s a dangerous habit to cultivate–the idea that I’m right, the market’s wrong and it will soon come to its senses. The reality is that I’m wrong maybe 40% of the time. Also, it could be that soon is the operative word.
At times like this, I go through this mental checklist:
- How dependent is my portfolio on this one idea? The riskiest situation is one where my holdings end up being an all-or-nothing bet on a falling oil price being good, without my realizing it.
- How likely is it that, contrary to my view, the market turns out to be right?
- If I wanted to rearrange my holdings to neutralize the effect of lower oil–meaning, in this case, becoming more defensive–how would I do it? Would these changes make any difference to my performance expectations? If not, why don’t I make them?
- If I were managing professionally, I’d ask if I should do some of this in any event, to guard against falling behind my peers (and ultimately getting fired–even worse, maintaining a portfolio that would pay off spectacularly for my replacement).
Most often, when I go through this process I find something in my portfolio that I don’t like and change it. Invariably the move improves my performance. But most often it has nothing to do with my original worry.
As to the market’s current fixation on oil, I have three thoughts:
–for now I’m content with what I hold and hope to ride out the craziness,
–I think this latest market kerfluffle brings us closer to the day when we’ll want to add oil exposure, and
–downward pressure on the market in December will translate into somewhat higher returns in 2016.
There is a thesis (that I’m sympathetic to) that oil and other commodities are canaries in the coal mine. This theory suggests that what has transpired is that we had (in the U.S.) a 13 year asset bubble (~ 1987-2000) fueled by ever falling interest rates and increasing debt levels that reached its logical conclusion circa 2000. Rather than running its course, this bubble was extended an additional eight years by further lowering rates. Bernanke experimented raising rates for about six quarters and got them positive (on an inflation adjusted basis) which precipitated the fixed income meltdown in the summer of 2007 and the fireworks of 2008. Rates were again lowered, this time all the way to zero. This bubble took on global proportions (Japan hit its limit around 1990 and has remained there since, Europe hit it about 2010 and China hit it last year). Dollar denominated stimulus started winding-down about 18 months ago, about the time commodities went from drifting down to free-fall. This week another step was taken to reduce dollar denominated (artificial) stimulus.
The thesis, if correct, suggests that the legacy of nearly 30 years of falling interest rates / mis-priced credit is a world filled with too much capacity, i.e., capacity that is uneconomic with real (inflation adjusted) positive interest rates. Much of this theory rests on the very high debt / GDP ratios found in most economies. To the extent the theory is about right, one would expect that rising interest rates now will have a similar effect that they had in 2006 – they will precipitate another crisis. Oil (and other commodities) are simply symptoms of the “too much capacity” aspect of this thesis.
Regardless if this theory is partially correct or completely wrong, securities prices are richly valued by historical standards (PE, price / BV, price / GDP). To the extent higher valuations equate to higher risk (not a provable thesis, but a conclusion I take as axiomatic), one should proceed with caution when investing in this environment.
Thanks for your comment, Chris.
I agree completely with most of what you say. I think the US stayed with easy money for far too long–and we’ll find out how damaging speculative excess has been as rates begin to rise. At the same time, the internet has changed the dynamics of ownership of physical assets. The aging of the population plus the unwillingness/inability of homeowners to use the equity in their houses to fund current spending will also be drags on consumption in the US. And we’ve come out of the big recession in better shape than the rest of the developed world. So we face a slow-growth world with lots of challenges for stock and bond markets.
As to mining commodities, though, I continue to think that they exist in their own boom-bust worlds whose main feature is that participants will add capacity, even though history has shown that this will destroy pricing, so long as they have positive cash flow and can get bank loans. Oil and gas are a little more complicated, but let’s ignore that. The ensuing slumps can last a decade or more. It’s the odd nature of these industries to produce more when prices decline rather than less. I regard the current weakness in the prices of mining commodities as resulting from industry weirdness rather than a recession-induced falloff in demand.
Of course, this is an optimistic viewpoint and I’m an optimist, so I could easily be wrong.
Does it make a difference whether oil and iron ore price declines are harbingers of general economic weakness or just playing out a new day in their Groundhog Day universe?
I think it does.
If I’m correct, then mining weakness, although important, is another entry to add to the list of transformational issues facing today’s world. That list includes:
–Millennials vs. Baby Boomers
–China as the world’s biggest economic power
–the disruptive power of the internet
–political reaction to the failure of the governments of the US, EU and Japan to enact appropriate fiscal policy, defending entrenched special interests instead.
In the world I envision, it will be hard to make money by owning stocks, but it’s possible.
If, on the other hand, if you’re right that mining commodity price weakness is the harbinger of a global economic contraction that just hasn’t hit mainstream indicators yet, then my take is way too positive. Cash will be the best place to be.
Good points – it is interesting to see how the Internet has moved passed the news paper industry and is now making a significant impact other media (VIA vs. NFLX) and on retail (e.g., SPLS) and likely retail derivatives (e.g., shopping center REITs). I think you mentioned that millenials are returning to department stores? If so, does that have a potentially positive impact on companies like DDS and M, which currently look pretty modestly valued?
I haven’t looked at the department stores for years, so I don’t know.
The big picture story of emergence of the Baby Boom and the move to the suburbs was the dismemberment of traditional department stores by specialty retail. That movement began to reverse itself as companies like Target and Costco became more prominent. And the trend seems to have gotten legs from Millennials.
My worry/question about the department stores would be whether they have the management strength to keep Millennials as customers or whether they’re still unimaginative purveyors of own-brand merchandise that has nothing special going for it. On the other hand, at 9x earnings and yielding 4%, expectations for M look really low.
I started writing this uninterested but now think I should take a serious look. Thanks.