Market volatility was present throughout January with no calming so far in February. We saw a 565 point intraday slide on the Dow on January 20th; then a few days later, the market closed up nearly 400 points! In February's first week, the Dow gave back all of that 400 point gain and an additional 261 more points. On Friday, the jobs report was +151,000; while it missed Wall Street estimates, it was still strong enough to scare the market into thinking the Fed would tighten again in March. (Not likely!)
- So far, everyone is at a loss to explain why falling oil prices would/could trigger an equity sell-off. Aren't lower energy prices good for the economy?
- It appears that we are still in correction mode. Is this a buying opportunity? Or is this the beginning of a bear market as a recession approaches?
The Correlation of Equities to the Oil Price
There are very few explanations as to why falling oil and equity prices have become so highly correlated. Economist David Rosenberg appears to have a reasonable one.
Over the 40+ years of OPEC, there has been an epic and historic wealth transfer. Nearly all of the producers in the cartel ended up with so much money that they developed massive sovereign wealth funds. These funds now hold 54% of the value of the world's equities.
According to Rosenberg, the slump in equity prices is not due to falling oil prices being negative for the world's economies. He says that it is possible that falling equity prices reflect "the run down in sovereign wealth fund reserves," cashing these in to finance their fiscal deficits. "In other words, the tight link between oil and equities is more fund-flow related than any nefarious message on global growth."
The falling oil price has caused real pain for America's oil industry, which has now become the swing producer, a role usually assumed by Saudi Arabia. But because it has taken much longer than anyone could have forecast for America's and the world's daily oil production to decline, the intense pain is now also being felt in some OPEC producers. At current prices, 90% of global oil production is uneconomic, and therefore, unsustainable. Small members Ecuador and Venezuela have been asking OPEC to restrict supply; so far, their voices have been ignored. But, sooner or later, OPEC (or market forces) will make the modest supply cuts that will push the oil price back toward $50. When that occurs, all of the anomalies associated with the weird attachment of asset prices to the price of oil will disappear.
Just a Correction?
Market negativity abounds - and volatility results. The latest fears have to do with corporate debt. We are told that corporate leverage is at a 12 year high, and credit rating agencies have downgraded more corporate issues than at anytime since '09.
The trouble with this line of thinking is that it begs the real question - can corporations afford their debt? As someone who often looks at corporate balance sheets, it is very evident that over the past 7 years, corporations have spread their cheap debt out over several decades, so they are, for the most part, insulated from rising interest rates. The scare also ignores the strength of corporate balance sheets, most of which have record levels of cash, cash equivalents, and other current assets. As for credit rating agencies downgrades, realize that manufacturing is weak and the oil patch is faring far worse - why are rising credit downgrades so surprising? Let's not dismiss this out of hand, however. Moody's said that their downgrades are now spreading to non-energy sectors. So, it is best for fixed income investors to stay away from the high-risk, high yield markets.
Meanwhile, real Q4 GDP came in at a paltry 0.7% growth, taken down by rising imports and falling exports (the strong dollar), and shrinking inventories. The picture painted is one of deteriorating economic growth. What's missing? The positives!
- Q4's average monthly employment growth was 279,000. We've rarely seen quarters this good in the post- recession period.
- January's official employment growth was 151,000. The Unemployment Rate fell to 4.9% (first time with a 4 handle in 8 years!). Construction jobs grew 18,000, retail by 58,000, and, surprise, surprise, manufacturing added 29,000! Monthly earnings grew at a 9%+ annual rate and the workweek expanded.
- It is hard to explain how business could be as negative as Wall Street portrays and be adding so many jobs. In fact, the number of job openings is now higher than the number of available workers!
- The dollar weakened significantly during the past week; this is good for exporters, multinational corporation earnings, and dollar denominated emerging market debt, and it also causes oil prices (in terms of dollars) to rise.
- So far, corporate earnings have been decent: U.S. banks, Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Coach (COH), McDonald's (NYSE:MCD), 3M (NYSE:MMM), and Ford (NYSE:F) (which had the best earnings ever!).
There are lots of scares on U.S. and global growth in the financial markets. While the underlying fundamentals have retreated, they are nowhere near recessionary levels. That doesn't mean that the current market pain won't continue. Volatility is likely until OPEC decides to restrict supply or free market oil production (i.e., U.S.) falls. Investors who look beyond OPEC's lunacy, which will end, may best be served over the long-run.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.