Long Term Investors, Remain Defensive

It was classic bear market action last week. The Dow was pounded for 4.2% (down 14.5% year-to-date), and the S&P 500 sank 3.0% (down 12.9% y-t-d). Two-year government yields dropped 27 basis points to 2.63%, while 10-year T-note yields fell 20 bps to 3.97%. Crude oil jumped another $5 for the week, to close over $140/barrel for the first time ever. Gold bullion surged $26/ounce to $928, and indexes of major gold stocks rallied over 8%.

With the S&P 500 back near major support at the 1270 level, which marked the lows reached in January and again in March, investors are asking themselves where do we go from here? Will buyers step up to defend these lows in stock prices as they have in the past? Or is the S&P 500 poised to break decisively into "official" bear market territory (more than 20% below the bull market peak)?

Stocks have reached oversold conditions that would normally signal a short-term bottom even in the context of a bear market. Since the rally off of the March lows ended on May 19, the S&P 500 has dropped 11% from 1440 to 1278. Most of this damage has occurred in the month of June, which (pending one more day of trading) is on track to be the worst stock market month since September 2002. However, the prospects for a near-term rebound are clouded by the uncertainty of the oil market and the possibility of a break of key near term support levels in stocks. Moreover, we are not seeing the signs of investor fear and panic that marked the lows in January and March. The VIX volatility gauge, which spiked to the mid-30s at those prior bottoms, is only at 24 today. Similarly, put/call ratios do not reflect the same degree of concern that prevailed during previous market lows.

In the bigger picture, it appears obvious that stocks remain in a bear market, so longer-term investors should retain a defensive posture. The economy and the stock market are being hit with a "perfect storm" of record high oil prices and the continuing fallout from the bursting of the credit and housing bubbles. Crude prices are now 40% above the inflation-adjusted peaks of prior energy crises, and are clearly exerting a major negative drag on an already weak economy. From an investment standpoint, it is prudent to stay cautious until oil prices back off in a significant way.

Given the dire state of the U.S. banking system and the recession in the U.S. economy, we were not surprised that Bernanke & Co. left the federal funds rate unchanged last week. However, by failing to back up its recently hawkish inflation rhetoric by actually raising the official overnight lending rate, we think the Fed missed an opportunity to take some air out of oil prices. On the day following the Fed decision, the market quickly rendered its verdict by pushing oil and gold prices sharply higher and sending the Dow Industrials into official bear market territory.

A reprieve in the relentless oil price spike is badly needed for stocks to regain traction. Oil is very overbought and due for a correction, but the momentum in the market is astonishing, and the market now has the $150/barrel target in its sights, so anything is possible in the short run. One example of how carried away the oil market has become is that an expected rate hike from the European Central Bank (ECB) this coming week is being widely discussed by oil market participants as the catalyst to push the price of oil to $150. The logic is that as a result of the ECB's rate hike, the Euro will move to new highs versus the U.S. dollar, and since oil has become the anti-U.S. dollar trade, oil will move higher.

Of course, the whole motivation for the ECB to hike its interest rate is to contain inflation pressures, led by oil. It is interesting to see, once again, how news is interpreted in the most bullish light possible when a mania takes hold.
 

Comments

[John Pseudonym:]

If the price of oil drops significantly (The charts suggest it will to me) then that will boost the economy.

Is a boost in the economy what the stock market wants? Won't that drive inflation, oil prices and interest rates higher? Won't higher interest rates further sink the banks and housing?

This is an excess circle and excess needs to be squeezed out the system. Will it be a fast or slow cleansing? I've betting on the slow and painful path and the government will do all it can to avoid the unavoidable.

2008 Jun 30 10:39 AM

[Jim Hawthorne:]

Why are we still insisting that "oil is priced in US dollars"?

Whether we like to pretend otherwise or not, oil is priced in terms relative to other major currency movements as well as those of the dollar.

Chart the price of crude relative to the US dollar/Euro exchange rate (ERO vs USO will do in a pinch!) and you'll get the picture!

Don't mention it.

2008 Jun 30 08:57 PM

[The pessimi...:]

Invester fear and panic have all but disappeared IMO due to the drops already experienced earlier this year. I will be amazed if we do not see another 400 points skimmed off the DOW. How then will investors react is anybody's guess.

2008 Jun 30 10:49 PM

[Tao:]

Investors can be compared to an old dog that has been around a lot of mean kids. Been kicked and punched so many times that the dog just lays there waiting for the next blow.

2008 Jul 01 12:01 PM

[jjason:]

J.D. have you read Philip Davis on "paper oil" on seekingalpha?

Also, we need to have oil prices drop back to $50 or $60 per barrel.

Read what Ed Wallace has to say at:

http:star-telegram.com/ed_w...

and Michael Greenberber's report at:

www.commerce.senare.go...

Too many people ( for example...Henry Paulson and Sam Bodman ) are either uninformed or are lying to us about the speculation that is going on in the commodity markets.

We are being cheated by the same people who allowed Enron to manipulate energy prices.

If Congress increases margin requirements and make it mandatory for futures traders to take delivery of the commodity then there will be fewer speculators in the commodity markets.

Congress is working on this problem now. Please inform your members of Congress that you want to see an end to speculation in the commodities markets.

2008 Jul 04 11:30 AM

[jjason:]

Sorry about the typing error folks. Go to:

www.commerce.senate.go...

2008 Jul 04 11:33 AM