On Tuesday oil climbed 9% on fear of geopolitical issues in Libya disrupting supply. Since, it has hit $100 per barrel as fear levels rise. The rational person is willing to wait and see what happens. Does oil stay at these levels, recede when 'normal' returns, or does it move even higher? The irrational or fearful person will react, maybe run out and buy a smart car to cut their consumption costs. Either way, the uncertainty being created by the rise in oil prices isn't good for the markets short term.
The calculators are out and analysts are figuring at what point the price of oil and gasoline will impact the economy. The answer will be different relative to perspective, but we know in 2008 that oil cost $140 per barrel and gasoline was $4 per gallon. This had a great influence on the consumer and the wholesale price of goods. For now, it is a reasonable assumption the same result will take place as we move forward. Nationwide, the price of gasoline is $3.25 per gallon at the pump. The ripple effect is hitting airlines and in turn the price of tickets. FedEx has added back a fuel surcharge on packages, and consumer gasoline consumption has turned flat. Wall Street is watching for the tipping point relative to the price of oil and the economy.
It is rational to believe if oil prices continue to rise, the effect to the U.S. and global economies could be a double dip recession. This result would put fear back into the market. On Tuesday, the Volatility Index jumped 26% as oil prices climbed showing the spike in fear from investors. The S&P 500 in turn has dropped from 1343 to 1306 or 2.7%. The drop is mild thus far, but it could easily accelerate to the downside if fear continues to rise in relationship to the price of crude and geopolitical issues around the globe.
Inflation is a concern, but it isn't the normal type of core inflation we study in economics 101. It's more of a tax/inflation caused by higher energy and food prices. Just a week ago we were discussing commodity inflation relative to agriculture cost rising. Cotton has nearly tripled versus 12 months ago. PowerShares Agriculture ETF (NYSE:DBA) is up 52% since June 2010. Throw in crude oil up 36.9% and gasoline is up 43% during the same time frame and you can see the tax/inflation on the consumer. Historically, this additional cost will recede based on a drop in demand. Is that going to happen this time around?
The bigger question is how we address these events and their current and future impact on our portfolios? The first mistake we want to avoid is not taking these issues seriously. It is easy to brush off the events as a temporary setback in the equity markets with the assumption we should be buying on the pullback or dip. This could grow into something more if the events stymie economic growth. Of course, the outcome will take time to determine, and that is where the challenge comes into play. Determining how to manage money in the face of uncertainty is the biggest challenge investors face. Thus, coming up with a plan of action is vital.
5 Steps to Managing Money in Current Markets
1) This is a pullback, not a correction. The market is right sizing. Use the November 2010 pullback as a benchmark. The May to August pullback could be an example if geopolitical issues expand. Either way investors can see clearly how to manage the pullback.
2) Manage portfolio risk. Sell the laggards and raise cash to take advantage of the resulting opportunities.
3) Accept this as a traders' market. Non traders hold cash and build a watch list of leaders that hold up throughout the pullback period. Those will be the leaders when the market resumes its uptrend.
4) Look for support on the S&P 500 to be in the 1225 range, 1200 worst case. Having realistic expectations help prevent investor anxiety.
5) Investors should be patient! Don't force positions and don't overreact to the news events. Building cash helps to dampen risk and emotions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.