We admit it, we are scared of the market, given all the squabbling in Washington, and fears on everything from inflation to growth. But a step back to consider things more objectively makes the overall picture considerably less bleak than it seems at first.
Bear markets rarely, if ever, start out of the blue. Bear markets - declines of more than 20 percent in either the S&P 500 or another major asset class - typically result from two factors. One, the asset - whether stocks, bonds, or gold - divorces itself from underlying fundamentals. Second - and this is critical - there is always a catalyst present, a sharp and sudden change in underlying economic conditions that undercuts the asset, making its level impossible to sustain. In some cases the catalyst creates the fundamental change. In some cases the catalyst simply underlines the obvious, that fundamentals can no longer support the market.
Either way, the sudden negative change forces investors to reassess the market, and see the lack of support for its unwarranted height. To the extent the market is divorced from fundamentals, the market is reclassified as a bubble and falls upon the appearance of a catalyst.
Today we hear much discussion: is the market overvalued and due to fall or still cheap enough to invest? Here is the point we want to make: Even if you accept that stocks are richly valued relative to underlying growth, you are betting against overwhelming historical odds if you get out before there is a compelling catalyst that shows beyond a doubt that growth is not sustainable.
Few can correctly time bear markets, primarily due to the difficulty of predicting the moment that some major change will create conditions under which the market separates undeniably from the fundamentals. For example, in the late 1990s, stocks by virtually every measure were extremely overvalued, yet continued rising. At the time, inflation was contained and earnings continued to rise. But sooner or later, growth (especially the rapid kind) emphasizes factors that short circuit it. And sure enough, toward the end of the decade oil prices rose sharply - acting as both a tax on the economy and an inflationary engine. The stratospheric rise in oil prices created exactly those conditions needed to eventually undercut ultra-high valuations. That was the pin that pricked the tech bubble. We would also argue that had the gain in oil been more moderate the Fed would have had adequate time to deflate the bubble much more methodically.
Flash forward to 2008. Stocks were richly valued and high home prices were unsustainable. Indeed the latter had been flashing red for more than a year. Even by then-current reckoning, a recession had started in late 2007. Yet stocks continued rising. Then came a spectacular rise in oil prices, and suddenly nothing made sense. The economic bubble collided with a huge new "oil tax," i.e. high prices, and rising inflation. The rest is history.
Was the massive bust inevitable? No one can answer that one. But we do know that the Fed was aware of the housing bubble long before the bust. Had they taken action earlier, very likely they also could have better controlled the housing market slide. Despite many differences between the U.S. in 2008 and China in 2010-11, China provides evidence that a government can handle an isolated bubble, provided it is not also accompanied by an unexpected event. In 2010, widespread social unrest or a major oil price hike, for example, could have doomed China's economy. But neither surfaced, so government controls worked.
Virtually all major market declines since the early 1970s were preceded by sharp increases in oil prices, that is, jumps of 85 percent or higher from the lows of the previous 12 months. The suddenness of the increase is critical. In 2012, a very good year for most markets, oil prices set a record, as measured by the average annual price for Brent Crude. Despite that, the price increase was quite mild. Indeed, not once during 2012 were oil prices even 20 percent higher than their minimum for the previous 12 months.
We noted this oil-economy relationship in our 2004 book "The Oil Factor." What we then observed has continued working for nearly a decade. Indeed it makes sense to use an indicator based on oil prices alone, calling for a sale or short upon a sharp gain and a buy when the oil price increases moderate. This simple indicator would more than double capital gains in equities.
One might conclude, given the emergence of fracking, that the U.S. market is shielded from major oil shocks like those of the early '70s, 2000 and 2008. Many believe the U.S. is close to energy independence or that, by 2020, will no longer rely on foreign oil. They also therefore predict that market declines, from here on, will be mild. They are seriously mistaken.
Sharply rising oil prices in today's environment would again create a double economic whammy - the equivalent of higher taxes and inflation. They would also signal defeat for one of America's great hopes.
It still pays to watch oil prices. In fact, it pays more than ever. Even if U.S. oil production continues to rise, this would not guarantee a control on oil prices. True, oil prices within the U.S. are less than prices elsewhere. But the discrepancy does not entirely result from increased U.S. production. Rather inventories of oil, not easily dispersed from one American region to another, tend to accumulate. Other countries, far less dependent than the U.S. on imports, price their oil according to a worldwide benchmark like Brent. West Texas Intermediate ((NYSE:WTI)), the price often quoted, no longer provides a global marker thanks to inadequate U.S. pipelines and other special transportation glitches. Indeed, over the last five years, Brent crude has provided a much better predictor of gasoline prices than WTI. Moreover, countries like Brazil that are nearly energy independent pay much more for gasoline than the U.S.
Most importantly, world oil prices count more than U.S. prices largely since the former also directly or indirectly determine prices of every material object. If world oil prices suddenly exploded upward, so would virtually all other commodity prices, including that of oil produced in the U.S. The break-even point for shale oil sits at a high $90 per barrel, since its production requires lots of oil, at least indirectly, to get the shale oil out of the ground. Iron ore, one of the most abundant materials on the globe, since the beginning of 21st century has closely tracked the price of oil. Why? Transportation costs add a huge chunk to its price.
Oil - despite cocktail party chatter - still matters. More than anything else, it probably determines whether we'll see another severe market cataclysm. Or more accurately, when.
The good news in this narrative is that at least for now, while oil prices are rising, they are rising at a very moderate rate. If all of a sudden for any reason oil prices start to gallop ahead that would be a warning that you should come back from your travels.
How high would oil have to rise in how short a time? Here is even more good news. In order to become really worried we would have to see Brent oil trading well above $150 a barrel. That may seem a long way off but if there is anything we have learned in the past five or so years is how fast things can change. But until you do see some sort of spike in oil, this remains a "buy the dip" - rather than "panic on the drop" - market.
Finally, we have to leave you with one caveat. If you do make oil your key longer-term indicator to watch, it does not mean you should take your eyes off everything else. A sharp and sudden change in any key economic variable from the dollar to bonds should be at least a yellow flag.