Oil Likely To Signal Next Market Correction, Eventually

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Includes: DBO, DIA, DTUS, IBB, OIL, QQQ, SPY, TAPR, UCO, USO, XLV
by: Daniel R Moore
Summary

Tech stocks continued to out-perform the broad market in the 1st quarter of 2015, while the U.S. market was volatile and flat.

Major U.S. Equity Markets are historically expensive on many relative measures, but a sustained market correction remains low in probability.

This article reviews factors that typically coalesce to precipitate major stock market corrections, and what to look for in the oil and Treasury market to gauge when risk is imminent.

The trading pattern of the major U.S. stock indices (NYSEARCA:DIA) (NYSEARCA:SPY) (NASDAQ:QQQ) during since the beginning of 2015 is best described as sideways and volatile.

A review of the equity market indices shows the 50 day moving average of DOW and the S&P500 barley maintained a positive slope in the first quarter, while the trading range showed a loss YTD of almost 5% in early February only to recover to a positive 2% by early March, a range of 7%. The tech heavy NASDAQ was a better performer in the first quarter, providing relative gains of 2% for the 1st quarter, and currently up 3% for the year. This pattern is indicative of a market in which stock buyers are increasingly wary of the valuations of large capitalization stocks which are expected to suffer earnings hits in the coming quarters because of a strong dollar, while riskier bets on technology that derive benefit from lower overseas cost of goods paid off.

The market dichotomy of technology outperformance while more commodity based industries suffer is not unusual. There are two instances in recent history where the major market indexes were driving to new highs while commodities, and in particular oil, suffered major corrections - the mid 1980s and the late 1990s. The actual market characteristics are decidedly different today; for one neither of these last two points in history had a zero-bound interest rate policy at the Fed. In addition, there is no major technological discontinuity today such as the analog to digital transformation in the 80's or the dot.com boom of the late 1990s. However, the investment pattern is similar. And the tendency of investors to see relative value in technology over alternatives is evident, not only in the U.S., but also in foreign markets, particularly China (U.S. Dot-Com Bubble Was Nothing Compared to Today's China Prices - Bloomberg, April 7, 2015).

Why are market investors currently bidding up the values of technology firms which are characteristically cash burning bets with a few big hit survivors, versus continuing to plow money into the more conservative stocks? It is within the context of this market scenario that is beginning to play out in 2015 that investors need to continue to assess the likelihood that the U.S. equity market will "correct" from its lofty relative valuation levels before the new tech bets being placed can pay-off.

Assessing the Risk of a Stock Market Correction

If I had only one factor to follow to assess whether the U.S. equity market was going to undergo a significant correction at the present time, it would be the oil market. Why? The assessment comes from tracking the interaction of a set of variables shown in the table below which historically have reached warning levels leading up to a market correction. Currently many of the variables are at warning or precautionary levels. However, oil is very accommodating to the U.S. economy. The question becomes, how long will the positive tailwind from a lower real cost of energy remain in place?

I reviewed the financial signals in the above table at the beginning of 2015 in a blog post - U.S. Stocks Living on Borrowed Time as 2015 Begins. If you want a detailed assessment of each variable trend and how the status of each variable relative to the market peaks in the year 2000 and 2007, I recommend that you review the report. In this article, I focus mainly on the recent changes that I expect will drive the market over the intermediate-term.

During the 1st quarter, the model continued to show increasing probabilities of a market discontinuity, but was still not "ripe" for a major correction. Yes, the market is expensive on a relative historical basis. And, the debt market is showing higher and higher levels of leverage; but the delinquency rates on loans remains historically low and the mortgage market continues to improve. Risk premiums are low. As a credit analyst by trade, I know this environment will change. But for now the data is signaling a pre-game warning, not an imminent collapse.

Fed policy has switched to the job of normalizing interest rates, and likewise produced plenty of fear forecasts. Will the stock market crash "like it did in 1937" if the Fed raises interest rates right now? Historically the data say it will not do so, at least not immediately. The current reality is that real economic activity is unlikely to be affected by the small rate increases being projected by the Fed at this time. There may be some valuations challenged if margin buying activity goes down; but I suspect that loan activity as a whole will not be affected. In fact, it may increase. Thus, the prospects for the Fed to raise rates, and the flattening of the Treasury yield curve while riskier asset spreads have tended to diverge, also do not meet the test of signaling an imminent market correction.

International Spark Linkage to Major Market Corrections

If marginal changes in Fed policy, or continued levering up of the U.S. market are not likely to cause a "shocking" stock market correction, what would do so? Historically there always is a trigger. The spark is most often launched from the international financial sphere, which then sets off a chain of events which produces faster rates of change in U.S. domestic policies - fiscal and monetary. The sharpest downward stock market corrections have historically happened when actions taken affecting current policies is high, and the uncertainty created by the changes is great. It is not unusual in very recent history for the changes to coincide with major presidential elections (2000 and 2008).

What is the best method to monitor the possibility of the international markets upsetting the current U.S. equity market party? Some track change in the relative strength of the dollar. But I prefer to watch activity in a real market that will change the behavior of policymakers, consumers and businesses. The energy market meets this test, and it has good predictive qualities when reviewed historically. Therefore, in the model, I track the oil market. The year over year change in the spot price of oil (NYSEARCA:OIL) (NYSEARCA:USO) (NYSEARCA:UCO) (NYSEARCA:DBO) is a quantifiable gauge of the international force on the U.S. economy which when the situation is "ripe" almost always signals an impending stock market correction.

When do Major Oil Downward Shocks Spell Trouble for Stocks?

As a generic rule most "economists" will say that higher oil prices are negative for economic growth and therefore are expected to drag the stock market down, and as a corollary lower oil prices are a net positive which spurs growth and should be good for stocks. What does the historical data actually show? Is this "rule of thumb" correct, or an investment myth?

The graph above plots the year over year change in the price of oil since 1971 and the points in time when the U.S. stock market (DOW and S&P500) registered extended year over year losses (maroon shaded area). Based on the graph above, as far as stocks are concerned the impact of changing energy prices depends on a number of factors. The rule of thumb view, while correct over the long-term, is subject to the lags and situational dynamics over the short-term. However, when extreme activity in the oil market is registered, whether a price spike or a downward shock, the stock market has a better than random chance of being impacted within 2 years.

Oil price spikes, where the price of oil doubles or even triples to a new all-time high as in 1973, 1980, 1987, 1990, 2000 and 2007, are closely associated with historical periods when the stock market registered steep market corrections. In virtually every oil price spike since 1973, international driven tension was a core common denominator.

There are two exceptions in recent history that have high relevance to the oil market dynamics in 2015. That dynamic is that the oil market experienced an extreme downward shock cutting prices by more than 50% due to market over supply issues - see 1985 thru early 1987 and 1998-1999. The ensuing retracement price "spike" became a situational factor that coincided with tightening Fed policy that exacerbated the impact on stocks. In 1987 the Fed had room to quickly loosen the reins and the "flash crash", although historically steep, dissipated quickly. The level of interest rates and the U.S. fiscal policy was in a far different relative position in 1987 than the year 2000 and 2015. For this reason, I do not view the 1987 example as a good case study for the investment scenario faced today.

The year 2000 roll-over in stocks was a multi-year correction scenario well known as the dot.com bust. Stock market instability was not immediately addressed by Fed policy in the year 2000. The market was viewed by most policymakers as being in "bubble territory." Post election, there was a dramatic shift in fiscal policy (Bush tax cuts) and then unexpectedly the 9/11 attack was a prelude to the Wars in Afghanistan and Iraq. The international trigger was pulled, and domestic policy, both fiscal and monetary, were in a state of high flux. The situation was perfect for a steep and prolonged stock market correction.

Based on the historical pattern, investors would be well served to pay close attention to the magnitude of any oil market retracement over the next 12 months after the dramatic decline that began in September of 2014. Low oil prices are favorable to U.S. consumers at the present time. I suspect that tech and pharmaceutical stocks (NASDAQ:IBB) (NYSEARCA:XLV) will continue to outperform over the short term. Tech dominated in 1999. But just as in 1999 the situational factors that are supporting current market valuations are stressed. A reversal "spike" in oil prices heading into 2016, if it does happen, would likely deal a detrimental blow to stock market valuations if the spike coincides as expected with Fed policy tightening as it did in the year 2000. The Fed is attempting to sooth such market fears by making statements that any interest rate policy actions will be small and shallow. In jawboning support, Saudi Prince Alwaleed bin Talal has gone as far as to state publicly that oil will "never" see the $100 price level again. (MarketWatch, Jan 2015). Never is a long time.

There is plenty of conflict in the international sphere involving major oil producers like Russia, Saudi Arabia, Iran and Iraq to name a few that could explode at any time turning the current oil surplus quickly into a deficit. In addition, the curtailment in capital expenditures in U.S. based shale production in 2015 is now beginning to show up in production, and will take some time to re-start if the industry over-shoots in the cutting process. Expect investors to be reluctant to jump on the shale band wagon quickly to supply new production capital given the industry shake-down going on presently. More likely, consolidation of players which keep a tighter rein on new supply is more likely.

Oil as a Stock Market Correction Trigger

Why would a rapid oil retracement at this time be a potent trigger to derail stocks? After all, the U.S. economy was exhibiting increasing growth in 2014 with oil over $100 per barrel.

One key that investors need to watch is the international flow of funds, particularly into U.S. Treasury reserves and more broadly into stocks in general. The recent downdraft in oil and commodity prices is quickly approaching the point in which the demand for U.S. Treasuries from oil and commodity based economies financing is decreasing. (Once Over 12 Trillion, World Reserves are Now Shrinking, Bloomberg, April 2015) In fact, drawing down on dollar based reserves across the board by emerging markets out of necessity to support their economies and make payments on dollar based borrowings may end up being the "wild card" story of the year. If a tipping point is reached, as it did in 1999 when the flow reversed for almost 2 years before resuming upward in August of 2001, trouble is likely to be looming for stocks.

Since foreign markets on the margin finance 50% of the public float, you can easily imagine the potential train wreck that is brewing. The current trend of U.S. Treasury interest rates being held low can continue short-term as long as countries like Japan and certain European allies borrow cheaply from their population and invest in U.S. Treasuries. However, just as the consensus that expected the price of oil to remain at $90 or above per barrel was wrong, the visible dangerous carry-trade between allied nations which is driving rates lower and lower will eventually be arrested. (NYSE:TAPR) (NASDAQ:DTUS) (DVFS).

Portfolio Strategy to Hedge Future Oil Market Tightening

What is the best course of action for your portfolio in the current skewed financial environment? My opinion is that steady re-balancing of your portfolio is the best "macro-prudential" approach. The goal in re-balancing should be to create higher and higher liquid, cash equivalent balances prior to the time an international trigger forces a dramatic shift in domestic U.S. monetary and fiscal policy. The upcoming 2016 Presidential election provides a perfect setting for international tensions to spark the needed uncertainty in policy that usually creates the perfect storm for a market correction. Investors can hedge this outcome risk by selling (preferably into rallies) small percentages of the over-priced equities or U.S. broad indexes , creating higher cash balances and moving a fraction of the proceeds into sectors that have suffered large declines in the wake of the current U.S. fiscal and Fed policy.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in EMD, TEI over the next 72 hours. 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.