Rising oil prices have pushed sentiment to levels of severe overreaction. It’s like being at a game where the home team is winning, but all the fans think that they’re actually losing! Whenever investors take their focus away from the scoreboard (data) and get caught up in emotional sentiment, it creates a disconnect between perception and reality.
As we begin a new quarter, it will be refreshing to turn our attention back to corporate earnings, back to GDP growth, and back to declining oil demand.
Here are four catalysts that will lead a second half market rally:
- High gasoline prices have not caused a consumer collapse. The data shows that Americans are exercising their freedom of choice by not allowing high gas prices to drain their finances. They are merely changing behavior and reallocating expenditures away from oil. 63% have changed their driving habits. 49% are scaling back on summer vacations. Vespa scooter sales were up 105% in May. The EIA just revised their gasoline demand numbers down for April to the lowest gasoline consumption levels in six years. Consumers will respond to soaring oil prices with mass conservation measures, investor Sam Zell said Friday on CNBC. "I think the American people and the rest of the world will cut the use of oil in the next 12 months to levels people never thought were possible," Zell said in a wide-ranging interview. He said the oil price spiral is not being dictated by pure demand and is instead subject to psychological pressures from a market that has been scared into thinking that things are worse economically than they truly are. Drivers are starting to obey the speed limit and are thereby saving 15-20% from increased fuel efficiency. SUV’s and trucks are disappearing from the roads. The conclusion: we can manage high oil prices. The American consumer is not nearly as weak as negative sentiment suggests. Over the last three months, core retail sales were up 10.2% while real consumption is up at an annualized 3.1% over the same time period.
- GDP growth refuses to cooperate with the recession forecast. The markets are now priced as if a recession has already occurred. Too bad this is far from the truth. First quarter GDP was revised up to 1.0% growth and second quarter GDP, set to be released on July 31st, could easily top 2.0% growth. According to analysis from Brian Wesbury of First Trust, excluding homebuilding (which is now roughly 4% of the economy) real GDP has expanded at a 3.3% annualized rate over the last three quarters. Never in history has a recession been declared with GDP data like this. Meanwhile, foreign demand for US products continues to boom, with exports up 19.2% over last year which has pushed non-housing real GDP up 3.6% during the past year. Yesterday’s ISM Manufacturing Index above 50 is another indicator of expanding GDP. According to Wesbury, this is the sixth month in a row that the index has beat consensus estimates. Sentiment is too pessimistic. The publisher’s of the ISM report indicate that the average index level of 49.5 in Q2 is consistent with a real GDP growth rate of 2.7%.
- An earnings season where all you have to do is show up. In the absence of real data, the market panics and assumes worst case scenarios. This has been the case for the last month. When we finally get some data, combined with extremely low expectations, we realize that the world is not coming to an end. Companies who merely meet expectations will actually surprise those who think that oil and financials have infected all sectors. It happened in April and will happen again in July. The current price/prospective earnings ratio of the S&P 500 is at 14. Rock bottom valuation will bring uninvested value cash back into the markets.
- Incumbents have to act if they want to be re-elected. Elected officials are under a huge amount of pressure to curb high commodity prices. I expect to see innovative legislation come from the recent hearings to limit commodity speculation. Without such legislation these leaders will have a near impossible chance at re-election. Many won’t even make it through their own party primaries. There is no way oil will be at $200 come November. To borrow a line from Wycleaf Jean... this ‘will be gone by November...gone by November’.
At the end of a game it is better to have a lead, being up by four points is always better than being down by four points. Sometimes we forget this simple truth and over analyze the game until we fool ourselves into thinking that we’ve lost. Investors are walking around like GDP is down 1% instead of up 1%. Oil, which is only one segment of the vast economy, has tainted our perception of where this market is headed. Brian Wesbury finishes, “The Fed is loose, tax rates are still low and productivity is strong. As a result, the economy will remain resilient, and avoid the most predicted recession in history all over again.”