Try as we may, we cannot find a case, other than today, in which the economy was weak and energy prices were rising rapidly. While the focus of this service is on resource-oriented stocks, with the economy so fragile we just can’t get too excited about the current upswing in energy prices.
Several years ago I devised a simple but effective stock market trading tool based on changes in crude oil prices. I first introduced this indicator in my book The Oil Factor. The premise of the rule is straight forward: falling or steady oil prices are good for stocks, while rapidly rising prices are bad for equities. The trigger for a sell signal is an 80 percent year-over-year increase in black gold. That kind of increase raises the cost of doing business, cutting into corporate profits, and it eats away at consumers’ disposable income, leaving them with less to spend on other items.
Since the 1970s, a rise in oil prices greater than 80 percent has resulted in stocks falling on average by more than 25 percent. And as we saw in 2008, sometimes the decline is considerably worse. In devising the indicator I used the somewhat arbitrary 1-year timeframe. Although prices on a year-over-year basis are negative, with West Texas Intermediate trading above $64 a barrel today, oil prices are up more than 80 percent from their December lows. That puts us once again in the danger zone.
Keep in mind that the price run-up doesn’t mean energy prices can’t rise further in the near term or that stocks will automatically collapse, but this is definitely a time for caution. Even the companies that are benefiting from the move in crude stand to take a hit if the economy backslides and demand wanes.
In addition to the gains in commodities, we’re also deeply concerned with what we see going on in the bond market. With short-term interest rates as low as they go, the Federal Reserve is buying up Treasury bonds in order to inject liquidity into the financial system. But this so-called quantitative easing is having no effect: The 10-year Treasury bond, the rate most consumer loans key off of, is nevertheless rocketing higher. So, too, are longer dated bonds.
There’s some merit in the argument that gently increasing yields is a sign that the economy is shaping up. But the rapid rise we’ve seen in recent months (the most on record for the 10-year Treasury) simply can’t be viewed as a positive. Instead, with the Fed’s balance sheet rapidly approaching $3 trillion, the rise in yields appears to be signaling that the inevitable swing from deflation to hyperinflation is now well underway.
Yet another sign of trouble to come in the equity market is the record amount of capital raised in stock issuance this month. According to Thomson Reuters, $48.8 billion in new stock was sold in May. Add in the $13.5 billion Bank of America (BAC) brought in via an at-the-market offering and the figure stands at an eye-popping $62.3 billion. The vast majority of this capital went to ailing banks trying to sure up their balance sheets and real estate investment trusts working to pay down lines of credit. New stock issuance is typically heaviest ahead of market downturns as companies take advantage of investors’ greed in the wake of share prices advancing.
If the economy was in better shape we might understand some of the recent euphoria. But the whole “green shoots” of economic recovery argument is quickly losing credence. The housing sector is not improving: prices are still falling, foreclosures are at a record and one in eight mortgage holders is behind on his payments. Throw in rising mortgage rates and unemployment destined to rise further in the coming months and the troubles in the housing sector are going to persist.
When the consensus is overwhelmingly on one side of a trade, watch out. The crowd usually gets it wrong. This axiom holds true not just for the stock market.
A survey from the National Association of Business Economists (NABE) out the other day showed 90 percent of the respondents believe the recession will end in the second half of this year with 74 percent of the economists thinking growth will resume next quarter. And the bullish call came even as the group lowered its negative forecast for the current quarter, as well as its outlook for subsequent quarters.
While many of these economists may be quite good at what they do, we suspect their forecasting abilities taken as a whole aren’t that great. Certainly their call seems to be based largely on desire rather than hard facts. The group missed the mark on the current recession by a wide margin: In February 2008, three months into the recession, they were projecting the economy would grow by 2.7 percent for the year. And it was several months after that before more than half of those polled thought the economy was contracting.
At some point, probably sooner rather than later, investors’ doubts about the health of the economy will trigger a sharp correction in the stock market. The size of that decline will likely be considerable. Given the rise in oil prices this year we can’t rule out a retest of the lows. The energy sector will prove to be a big winner in the coming years, but we caution you against holding too much of your portfolio in these shares at present as they, too, could take a beating in the near-term correction we’re expecting.
