Stocks started the week lower but reversed course mid-week to send the market into positive territory. For the week, the Dow gained 1.5%, the S&P rose 1.6%, and the Nasdaq added 1.9%. Gold closed the week with little change, down just 0.3%. Oil rose again this week, up 3.2% to $32.84 per barrel. The international Brent oil, which is used to make much of the gas here on the East Coast, moved higher to close at $35.44.
Source: Google Finance
We saw several smaller stories helping move the market this week, from the oil market to a number economic data releases.
The oil market has played a large part in the movement of stocks lately. There’s been a strong correlation, with up moves in the oil market often resulting in up moves in stocks, and vice-versa. The story was true again this week.
There are several theories as to why this is occurring, but news from banks this week gave us another clue.
First, banks have made loans to energy companies, but the low oil prices have significantly hurt these companies and increased the odds of defaulting on those loans. Investors remember how bad loans at the banks lead to the market decline in 2008. While it will not be of the same magnitude as then, the chance of losses still exist. Therefore, the further oil prices decline, the worse shape the banks are in. This is a big reason why oil and stocks are seeing such a high correlation.
Shining a spotlight on the problem, J.P. Morgan made headlines this week when it announced it was setting aside $500 million in reserves (the money it sets aside in case of losses on loans) due to chance of default on loans it made to the oil sector. They added that an oil price of $25 for 18 months will cause them to set aside another $1.5 billion.
J.P Morgan is not alone. Wells Fargo has already set aside $1.2 billion. Countless others are in the same boat, from large international banks like HSBC to smaller regional banks like Regions and SunTrust. All are at risk of losses on loans made to the oil sector.
Adding to investors’ concerns, many speculate the banks are underreporting just how bad the damages will be.
Banks must report an expense if it appears a loss on a loan is likely (called loan-loss provisions). The process is very subjective, requiring a lot of estimating. Because of this, investors never fully trust the reporting.
An article this week shows investors have reason to be skeptical. In the height of the 2008 crisis, banks held off from reporting losses to make themselves appear better off than they actually were. It’s probably safe to assume this is the case again this time.
Switching gears, economic data released this week was mixed, but the positive economic reports seemed to pressure the market as it means less likelihood for additional stimulus from the Fed.
As for the reports, housing was mixed as new home sales dropped sharply while previously-owned home sales rose slightly. Durable goods showed a solid increase, though that was largely due to aircraft orders. GDP rose more than originally expected, coming in at 1%, up from the 0.7% original estimate. Also, personal income and spending both rose at the best levels since last May.
We’re also nearly through earnings season as 95% of companies in the S&P 500 have reported earnings. According to Factset, companies are reporting a loss of 3.6%, which is better than the -4.7% originally expected – but it’s still negative.
The Wall Street Journal had a great article on why we should be especially cautious of these numbers.
A company officially reports earnings using the GAAP method of accounting. Without getting into the details, it’s a strict guideline the company must follow. However, a company can report unofficial “pro-forma” earnings, where a company uses discretion in what to report as to give what they believe is an accurate representation of the company’s performance. You can bet the pro-forma numbers will always be better than GAAP.
The Journal reports current GAAP earnings figures are 25% lower than the pro-forma numbers companies are reporting. The effect can be seen in the chart below. The true health of companies is much worse than we think.
The oil market has played a large part in the movement of stocks lately. There’s been a strong correlation, with up moves in the oil market often resulting in up moves in stocks, and vice-versa. The story was true again this week.
There are several theories as to why this is occurring, but news from banks this week gave us another clue.
First, banks have made loans to energy companies, but the low oil prices have significantly hurt these companies and increased the odds of defaulting on those loans. Investors remember how bad loans at the banks lead to the market decline in 2008. While it will not be of the same magnitude as then, the chance of losses still exist. Therefore, the further oil prices decline, the worse shape the banks are in. This is a big reason why oil and stocks are seeing such a high correlation.
Shining a spotlight on the problem, J.P. Morgan made headlines this week when it announced it was setting aside $500 million in reserves (the money it sets aside in case of losses on loans) due to chance of default on loans it made to the oil sector. They added that an oil price of $25 for 18 months will cause them to set aside another $1.5 billion.
J.P Morgan is not alone. Wells Fargo has already set aside $1.2 billion. Countless others are in the same boat, from large international banks like HSBC to smaller regional banks like Regions and SunTrust. All are at risk of losses on loans made to the oil sector.
Adding to investors’ concerns, many speculate the banks are underreporting just how bad the damages will be.
Banks must report an expense if it appears a loss on a loan is likely (called loan-loss provisions). The process is very subjective, requiring a lot of estimating. Because of this, investors never fully trust the reporting.
An article this week shows investors have reason to be skeptical. In the height of the 2008 crisis, banks held off from reporting losses to make themselves appear better off than they actually were. It’s probably safe to assume this is the case again this time.
Switching gears, economic data released this week was mixed, but the positive economic reports seemed to pressure the market as it means less likelihood for additional stimulus from the Fed.
As for the reports, housing was mixed as new home sales dropped sharply while previously-owned home sales rose slightly. Durable goods showed a solid increase, though that was largely due to aircraft orders. GDP rose more than originally expected, coming in at 1%, up from the 0.7% original estimate. Also, personal income and spending both rose at the best levels since last May.
We’re also nearly through earnings season as 95% of companies in the S&P 500 have reported earnings. According to Factset, companies are reporting a loss of 3.6%, which is better than the -4.7% originally expected – but it’s still negative.
The Wall Street Journal had a great article on why we should be especially cautious of these numbers.
A company officially reports earnings using the GAAP method of accounting. Without getting into the details, it’s a strict guideline the company must follow. However, a company can report unofficial “pro-forma” earnings, where a company uses discretion in what to report as to give what they believe is an accurate representation of the company’s performance. You can bet the pro-forma numbers will always be better than GAAP.
The Journal reports current GAAP earnings figures are 25% lower than the pro-forma numbers companies are reporting. The effect can be seen in the chart below. The true health of companies is much worse than we think.
Next Week
We’ll see another busy week next week. The data will be particularly important since it is the last week of significant reports before the Fed’s next policy meeting.
As for the data, we’ll get info on the strength of the service and manufacturing sectors, factory orders, and the always important employment report.
This could see the market go lower on good reports, as it would mean more of a chance of the Fed pulling back on its stimulus.
Investment Strategy
There is no change in our investment strategy. We appear to be in expensive territory in the very short term (a few days to a week-or-so). Looking out a little longer, we may still have more room to rise.
In the longer term we have concerns. The stimulus of the last several years masked many problems and caused a misallocation of resources and bubbles to form. It also prevented necessary changes from occurring at both a corporate and political level. As the stimulus is pulled back, those flaws become more apparent. We’re now seeing lower corporate earnings, massive debt levels, poor economic growth, and potential for recession. This will weigh on the market at some point, but the question is, when?
Bond prices have been very high (and yields very low). We think demand will keep prices high, though maybe not as high as we are currently seeing. We wouldn’t be surprised to see prices fall and yields rise from here.
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. Floating-rate bonds will do well if interest rates eventually do rise.
Some municipal bonds look attractive for the right client, too. We like buying individual, insured names for these bonds, avoiding muni index bonds if possible. We keep a longer term focus with these investments.
Gold is another good hedge for the portfolio and has showed it in recent weeks. It is only a hedge at this point – rising on geopolitical issues and a flight to safety.
Finally, in international stocks, we see weakness around the globe and favor neither the developed or emerging markets.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
We’ll see another busy week next week. The data will be particularly important since it is the last week of significant reports before the Fed’s next policy meeting.
As for the data, we’ll get info on the strength of the service and manufacturing sectors, factory orders, and the always important employment report.
This could see the market go lower on good reports, as it would mean more of a chance of the Fed pulling back on its stimulus.
Investment Strategy
There is no change in our investment strategy. We appear to be in expensive territory in the very short term (a few days to a week-or-so). Looking out a little longer, we may still have more room to rise.
In the longer term we have concerns. The stimulus of the last several years masked many problems and caused a misallocation of resources and bubbles to form. It also prevented necessary changes from occurring at both a corporate and political level. As the stimulus is pulled back, those flaws become more apparent. We’re now seeing lower corporate earnings, massive debt levels, poor economic growth, and potential for recession. This will weigh on the market at some point, but the question is, when?
Bond prices have been very high (and yields very low). We think demand will keep prices high, though maybe not as high as we are currently seeing. We wouldn’t be surprised to see prices fall and yields rise from here.
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. Floating-rate bonds will do well if interest rates eventually do rise.
Some municipal bonds look attractive for the right client, too. We like buying individual, insured names for these bonds, avoiding muni index bonds if possible. We keep a longer term focus with these investments.
Gold is another good hedge for the portfolio and has showed it in recent weeks. It is only a hedge at this point – rising on geopolitical issues and a flight to safety.
Finally, in international stocks, we see weakness around the globe and favor neither the developed or emerging markets.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
