All major US stock markets moved aggressively up in February, clearly breaking out of their two-month holding patterns. The S&P and Dow have even been pushing all-time highs since mid-February and CBOE VIX has been falling steadily in both markets. Doesn't that mean more good times ahead? While the US economy continues to grow, and the fiscal and monetary policy ahead are accommodative, there is one big nagging question on most investors' minds. When they look at the charts for oil, agriculture, base metals, they see that all commodities have fallen substantially over the last six months. Is this going to continue and is it a portent of a global slowdown ahead? I believe the answers to these two questions are no and no, but that doesn't mean there is no trouble ahead.
There is evidence that China was amassing large inventories of these commodities last year. That would partially explain some of the current price softness but not much. Rather it is the rise in the US dollar that explains a lot of the commodity price contraction, and this phenomenon may continue, albeit at a slower pace, for some time to come. Demand for US dollar-denominated assets continues to grow. US capital market products are in demand. US dollar monetary policy appears to be in support of a stronger dollar. Currencies continue to soften in countries/communities with slow growth and those who are large exporters of commodities.
The economist Harry Dent is infamous among analysts for his recent alarming prediction of a 6000 Dow by year-end 2015. He bases that on a model that commodity prices are falling because global demand is shrinking and will continue to shrink due to demographics. There is now around the world a shrinking bubble of aging middle class who will cut their spending as they become senior citizens. He has a compelling story supported by many demographic time charts and some empirical evidence from Japan on the impact of a shrinking middle age population, aka not being offset by either large-scale immigration or a burgeoning next generation. In some countries, for the next 10 years, this situation is real. But in the US, the echo boomers bulge is upon us. It turns out that this cohort is now settling down and forming households, en masse. The US metric for new households has recently been on the uptick, and based on demographics this will continue at least until 2018. Nothing drives real estate and big-ticket consumer goods spending like new household formations. Based on this, there is certainly not a US-driven slowdown and deflationary death spiral coming.
Regarding oil prices, it appears it was the US that created the current oil price plunge with their bloating inventories and growing (now 9 million bbl/d) production. Other than a .2 million bbl/d reduction by OPEC countries, there has been no pullback in production since the price fall. Even though the latest report from US Energy Information Administration shows that in February global supply and demand were in balance and total inventories change was net zero (0), the EIA also says USA production will continue to grow well into 2016; no country is planning a substantial cut to production except Canada. That is a market not yet in rebalance mode. Although the futures price curve is in contango (near month price $8 below the 13th month), suggesting price increases are coming soon, what is most likely based on supply/demand imbalance is a very near term further decline in prices. With lower prices, demand will continue to grow quickly and prices will drift back up. A looming risk is the amount of lost future production capacity from curtailed E&P that has occurred since the prices fell. This deferral cannot be quickly brought on stream to meet nascent demand when the time comes. One could easily envisage prices going aggressively the other way to new highs in just a few years from now. For now, we can all enjoy filling up at the pump.
A larger concern than commodity deflation is China's growth rate. It may moderate in 2015 given the contracting economies in commodity exporting countries that now represent a substantial portion of China's exports. Also, China has a potential housing bubble on its hands so according to IHS, China's official forecasted 7% growth for 2015 is probably overstated. If this becomes clear and the US dollar continues to rise, the Dow and S&P P/E ratios could soften drawing the market back from the all-time highs we're seeing now.
As long as earnings per share and dividends per share keep growing at 10%+ y/y, which so far has been the case, these P/E ratio adjustments would appear as a correction or two, with a full year market valuation growth still in the 10%+ range. However, there are signs of an overall earnings slowdown. According to MarketWatch, the energy sector and the rising dollar are taking their toll on total forecasted earnings, suggesting a real growth in 2015 of only 3-5%. Even with continued aggressive share repatriations, a 10% y/y EPS now comprehended in today's P/E multiple might not be realized. This would bring additional churn to the S&P and reduce if not stifle its 2015 growth. But if the dollar reverses its rise and oil reverses its fall, we could see in 2015 another 10%+ year.
Buy and hold investors in the broad market index funds such as PowerShares QQQ Trust ETF (NASDAQ:QQQ), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) or SPDR S&P 500 Trust ETF (NYSEARCA:SPY) could see a bumpy ride this year. To assure a good return by year-end, they should hedge for market corrections rather than just endure them.
Disclosure: The author is long DIA, SPY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.