The Real Reason Why Stocks Are Down

Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

It's been a rough week on Wall Street and some investors are panicking. One thing is certain. Complacency is gone. The VIX, the so-called "fear index," finished the day at almost 22. Just last Friday it was below 12. That's a remarkable jump in such a short period of time. We're not even half way through December, yet the Dow Jones Industrial Average is down 3.1% month-to-date. That in itself is very unusual for a month that typically benefits from the so-called "Santa Claus rally."

Some investors are blaming this sudden and surprising sell-off in stocks on oil prices, which have been plummeting. I don't buy that argument - at least not exactly. There is no doubt that the sudden plunge in oil prices is bad news for certain companies and their employees; yet for the majority of businesses, lower energy prices are good news. Furthermore, despite the increased amount of oil production in the U.S., we remain an oil-importing nation. Therefore, reduced oil prices should provide a boost to GDP from higher net exports alone.

Still, I do believe that the plunge in oil prices is contributing to the weakness in stocks, but in another more important way. It is happening through a signalling mechanism. Lower oil prices in and of themselves are not bad for stocks. What is bad for stocks is the reason why oil prices are falling. They are falling because the world has suddenly realized that demand for oil is much weaker than previously thought. In fact, just today, we learned that the International Energy Agency once again reduced its 2015 forecast for global oil demand.

Lower oil prices are the result of lower demand, and lower demand is sending a negative signal to investors about the health of the world's economies. China, home to the world's second-largest economy, is still growing at rates that make the rest of the world envious. Yet even China's growth appears to be slowing. Stock prices are falling due to the fear of what lower oil prices are telling investors - that global economies are in worse shape than they thought.

At this point you could rightly point out that the U.S. economy is doing just fine. Indeed, U.S. economic growth appears to be strengthening; and as I said earlier, reduced oil prices should provide an extra boost to GDP in 2015. So why should U.S. stocks fall in reaction to weaker economic growth elsewhere? The reason is because U.S. stock markets have already rallied in anticipation of a stronger U.S. economy. I would argue that stocks have gotten ahead of themselves. As a result, stocks could remain flat, or go lower, even if GDP growth beats expectations. On top of that, the U.S. economy is not isolated. Weak economies elsewhere are not good for our multinational corporations.

Of course, this is not to say that no stocks will do well. In fact, several stocks on my recommended list in the Money Masters Stock Report are having a pretty good time of it this month. Staples (NASDAQ:SPLS), which is up 17% month-to-date, is leading the pack. Yet there are many stocks that are not currently on my recommended list that are piquing my interest. In this regard, I decided to take a closer look at the individual names in the Dow Jones Industrial Average. Two of these blue-chip stocks, Chevron (NYSE:CVX) and International Business Machines (NYSE:IBM), are already in bear market territory. (i.e., they are down more than 20% from their 52-week highs.) Caterpillar (NYSE:CAT), Exxon Mobil (NYSE:XOM), and Boeing (NYSE:BA) are close to that 20% mark. AT&T (NYSE:T), Verizon (NYSE:VZ), and McDonald's (NYSE:MCD) are in correction territory (i.e., they are down more than 10% from their highs). As a whole, however, the Dow Jones Industrial Average is not even down 4% from the all-time high it set exactly one week ago.

So are investors right to panic? I don't think so. In my view, the sell-off in oil is a good thing for the economy and it's a good thing for most stocks. Still, I expect (and hope) that stock prices go lower in the short run. After all, I am in the business of putting money to work. I would rather do that at lower prices than at higher prices. Furthermore, I find it difficult to argue that stocks are overvalued despite the fact that most indexes are near their all-time highs.

Disclosure: None