The stock market turned in its first negative week in two months – and it was a rough one. For the week, the Dow plunged 3.8%, the S&P lost 3.5% and the Nasdaq dropped 2.7%. Gold did well on the turmoil, rising 2.7%. The story of the week was oil, which fell to new five-year lows with a remarkable 12.2% drop to $57.81 per barrel. The international Brent oil, used for much of our gas here in the east, also fell strongly to $61.92 per barrel.
Source: Google Finance
Stocks have steadily risen since their lows in October, so we figured they were overdue for a pullback. This week was a surprise in how strongly it moved lower, with the Dow turning in its worst week since 2011. Normally we could point to some news story or event as the catalyst behind the market moves. This week there was no such story – stocks largely moved lower just because oil moved lower.
Oil has fallen recently due to the amount of supply on the market. The U.S. has ramped up its oil production and that new supply has been bringing oil prices lower. It has also created a price war with OPEC (largely Saudi Arabia), who have resisted cutting back production to decrease that supply. All this has contributed to lower oil prices.
Lower oil prices are great for the economy, especially during this busy shopping period. Because of that, you’d think it would be good for stocks. In the long run it likely will be. However, the stock market has become nervous at the rate of drop in oil. The bottom has dropped out of the market as of late – just look at the decline this week – and strong, sudden moves of any market raises a red flag.
The drop in oil has hurt energy companies, who have been the worst performing sector over the past month. The lower share prices have brought in new investors who believe oil company stocks are undervalued and due to rise. However, oil prices keep falling, so the oil company stocks keep falling.
These oil company stocks will be a good buy whenever the price of oil does stabilize, but it’s anyone’s guess as to when that will happen. The current chatter among investors is many believe oil will bottom around $50 a barrel, a price we are rapidly approaching. Oil company stocks may be worth a look around that price.
Switching gears a bit, one impact of lower oil prices is it lowers the inflation rate. We saw that this week with in the PPI report, which shows inflation at the producer level. Inflation fell over the last month largely due to the decrease in energy prices.
We see this as a positive because it means the things we buy will cost less, allowing the dollar to go further. However, it is seen as a negative by central banks who have done all they can to create inflation, believing that is the way to improve the economy (the head of the Japanese central bank has actually said he is worried about lower gas prices – do you see paying less at the pump as a bad thing?).
With inflation running below central banks’ targets, it increases the odds they will do more stimulus to boost inflation. The Fed has been pulling back from their stimulus programs, so this may prompt them to hit the brakes or even increase stimulus. As we have often discussed, we believe it is a foolhardy policy, but stocks do rise on stimulus.
Lastly we need to touch on one story out of China. Their stock market saw the biggest one-day drop in five years this week as they took a step to reign in risky lending. Investors have been buying the riskiest junk bonds and using them as collateral to borrow money to buy stocks. Worried about the amount of risky debt in their economy, the government announced these junk bonds would no longer be accepted as collateral. Stocks plunged as a result.
This tells us there is an immense amount of speculation in the Chinese market. If things do go south, the drop could be very large and spill over to our market. This is something to keep an eye on.
Next Week
With the direction of the oil market having a significant impact on stocks this week, odds are investors will be keeping a close eye on it next week, too.
A few other items will be worth watching, including a policy meeting by the Fed. They have discussed changing the language of their policy statement (investors closely watch the wording of these statements to try to get an edge, so the language is largely left unchanged) to indicate interest rate increases are on the horizon. The record low interest rates have helped fuel the stock market rise, so raising rates could spell an end to the stock market rally. We’ll see if the decline in stocks this week will affect their decision.
Overseas, there will be elections in Greece and Japan. New leadership will have a significant impact on their economic policies, so investors will be watching this closely.
Investment Strategy
It’s probably too late to do any selling at this point and we are not looking to do any buying, either. History has shown stocks perform well in the late part of December just before the year-end, so this may be something to halt that drop in stocks. Also, above we mentioned the sell-off in energy companies and they may be worth a look if oil prices begin to stabilize (we’d stick with the bigger names and avoid smaller ones who are more likely to be hurt by the lower oil prices).
As for the longer term, we still have our concerns. We continue to have worries for the market due to market distortions created by the central banks and money printing. Stimulus continues to propel stocks higher, but we worry the longer it continues, the more painful the correction will be.
High yield (junk) bonds have been a big story since oil companies make up a large part of this asset class. They have also been a good leading indicator for the stock market, as you can see in the chart below (the orange line is the S&P 500 and the black line is high-yield bonds). High yield bonds have dropped sharply recently (the black line), which signals stocks may follow. No indicator is perfect, but it is a red flag to consider.
Oil has fallen recently due to the amount of supply on the market. The U.S. has ramped up its oil production and that new supply has been bringing oil prices lower. It has also created a price war with OPEC (largely Saudi Arabia), who have resisted cutting back production to decrease that supply. All this has contributed to lower oil prices.
Lower oil prices are great for the economy, especially during this busy shopping period. Because of that, you’d think it would be good for stocks. In the long run it likely will be. However, the stock market has become nervous at the rate of drop in oil. The bottom has dropped out of the market as of late – just look at the decline this week – and strong, sudden moves of any market raises a red flag.
The drop in oil has hurt energy companies, who have been the worst performing sector over the past month. The lower share prices have brought in new investors who believe oil company stocks are undervalued and due to rise. However, oil prices keep falling, so the oil company stocks keep falling.
These oil company stocks will be a good buy whenever the price of oil does stabilize, but it’s anyone’s guess as to when that will happen. The current chatter among investors is many believe oil will bottom around $50 a barrel, a price we are rapidly approaching. Oil company stocks may be worth a look around that price.
Switching gears a bit, one impact of lower oil prices is it lowers the inflation rate. We saw that this week with in the PPI report, which shows inflation at the producer level. Inflation fell over the last month largely due to the decrease in energy prices.
We see this as a positive because it means the things we buy will cost less, allowing the dollar to go further. However, it is seen as a negative by central banks who have done all they can to create inflation, believing that is the way to improve the economy (the head of the Japanese central bank has actually said he is worried about lower gas prices – do you see paying less at the pump as a bad thing?).
With inflation running below central banks’ targets, it increases the odds they will do more stimulus to boost inflation. The Fed has been pulling back from their stimulus programs, so this may prompt them to hit the brakes or even increase stimulus. As we have often discussed, we believe it is a foolhardy policy, but stocks do rise on stimulus.
Lastly we need to touch on one story out of China. Their stock market saw the biggest one-day drop in five years this week as they took a step to reign in risky lending. Investors have been buying the riskiest junk bonds and using them as collateral to borrow money to buy stocks. Worried about the amount of risky debt in their economy, the government announced these junk bonds would no longer be accepted as collateral. Stocks plunged as a result.
This tells us there is an immense amount of speculation in the Chinese market. If things do go south, the drop could be very large and spill over to our market. This is something to keep an eye on.
Next Week
With the direction of the oil market having a significant impact on stocks this week, odds are investors will be keeping a close eye on it next week, too.
A few other items will be worth watching, including a policy meeting by the Fed. They have discussed changing the language of their policy statement (investors closely watch the wording of these statements to try to get an edge, so the language is largely left unchanged) to indicate interest rate increases are on the horizon. The record low interest rates have helped fuel the stock market rise, so raising rates could spell an end to the stock market rally. We’ll see if the decline in stocks this week will affect their decision.
Overseas, there will be elections in Greece and Japan. New leadership will have a significant impact on their economic policies, so investors will be watching this closely.
Investment Strategy
It’s probably too late to do any selling at this point and we are not looking to do any buying, either. History has shown stocks perform well in the late part of December just before the year-end, so this may be something to halt that drop in stocks. Also, above we mentioned the sell-off in energy companies and they may be worth a look if oil prices begin to stabilize (we’d stick with the bigger names and avoid smaller ones who are more likely to be hurt by the lower oil prices).
As for the longer term, we still have our concerns. We continue to have worries for the market due to market distortions created by the central banks and money printing. Stimulus continues to propel stocks higher, but we worry the longer it continues, the more painful the correction will be.
High yield (junk) bonds have been a big story since oil companies make up a large part of this asset class. They have also been a good leading indicator for the stock market, as you can see in the chart below (the orange line is the S&P 500 and the black line is high-yield bonds). High yield bonds have dropped sharply recently (the black line), which signals stocks may follow. No indicator is perfect, but it is a red flag to consider.
As for the bond market, bond prices have risen sharply (so yields are lower) as investors pull money out of stocks and put them into the safer bonds. These yields are on the low end of their trading range, so we’ll see if they bounce back higher (so prices fall). At this point, it’s anyone’s guess.
European bonds, especially for the profligate countries, look extremely expensive at the moment and also look like fantastic short opportunities.
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. They have not done well recently, but are intended to be a longer term investment. Some municipal bonds look attractive for the right client, but not as good as they did several months ago. 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. It is only a hedge at this point – rising on geopolitical worries and falling once they are out of the headlines. It hasn’t fared well lately, but remains a good hedge for the long run.
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.
European bonds, especially for the profligate countries, look extremely expensive at the moment and also look like fantastic short opportunities.
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. They have not done well recently, but are intended to be a longer term investment. Some municipal bonds look attractive for the right client, but not as good as they did several months ago. 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. It is only a hedge at this point – rising on geopolitical worries and falling once they are out of the headlines. It hasn’t fared well lately, but remains a good hedge for the long run.
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.
