We bought last week when the S&P 500 tested the 2000
level. We bought more during the initial sell-off after the fed announcement.
The market went on to rally from there and we felt good about our position
fully expecting a follow-through on the day’s strong gains. That didn’t happen
obviously and what was a good month of trading suddenly wasn’t.
We are maintaining our long position and anticipate a bounce
from here. We are approaching the psychologically important 2000 level again.
That could offer some support. If we hold these levels we are also seeing a few
positive divergences in the internal mechanisms that we track. The market
closed at a lower low from the week prior but many of the indicators that we
follow closed at a higher low.
Oil Prices Weighing
on Stocks
Last week all I heard
on TV was that the market was weighed down by oil and the market wouldn’t catch
a bid unless oil prices stabilized. Perhaps that is true in the very short term
but outside of a broad conceptual relationship between oil demand, global
economic growth and the stock market, I didn’t recall a tight correlation
between the two asset classes. I was
going to run a few correlation tests but came across an article in the Pension Partners blog site
in which Charlie Bilello had already done the work.
He writes, “With the
S&P 500 struggling to hit new highs in 2015, much of the blame has been
placed on lower Oil prices. If only Oil prices were higher, say the pundits,
stocks would be soaring. But how accurate is this story? Do stocks really need
higher Oil to perform well?”
“We have data on Crude
Oil (Generic First Futures via Bloomberg) going back to March 1983. The monthly
correlation to the S&P 500 since then? Essentially zero (.05). Looking at
the rolling 1-year correlation, we can see there are times where Oil and
equities are positively correlated and other times when they are negatively
correlated.”
“Some thoughts on
their unpredictable relationship:
- From 1984-87, Crude declined every year while the S&P advanced.
- The S&P continued to advance in 1988 and 1989 while Crude rebounded.
- Then, in 1990, the S&P experienced its only down year in the 1982-99 period while Crude Oil was up 30%.
- From 1994-96 the S&P and Crude moved up together.
- From 1997-98, Crude declined while the S&P experienced two strong years.
- The 2000-02 Bear Market in stocks displayed no obvious correlation to Crude.
- From 2003-07, Crude and the S&P rose together during the commodities boom.
- In the 2008 deflationary collapse, they declined together and during the 2009-11 reflation they rose together.
- In the past two years, as Crude has suffered one of its worst declines in history, the S&P is higher.”
“Ultimately, the
correlation between Crude and stocks depends on why Crude is moving higher and
lower, which is difficult to ascertain in the moment. It only becomes clear in
hindsight. Certainly a crash in Crude as we saw in 2008 which was an indication
of a collapse in global demand was not going to be a positive for the U.S.
equity market. However, a crash in Crude due to increasing supply and
alternative forms of Energy could very well be construed as positive for
markets. Is that the case today? Again, we’ll only know in hindsight.
Ironically, while the
fear of the day is over lower Crude Oil prices, historically the opposite
situation has been more harmful for markets and the economy. If we look back at
history, 1-year spikes in Crude above 90% occurred in 1987, 1990, 2000, and
2008. All of these spikes were associated with equity Bear Markets and the
1990, 2000, and 2008 spikes associated with U.S. recessions. So perhaps the
greater fear should be not a continued slide in Crude but a spike higher.”
More on the Economic
Front
Most economists are saying a recession is nowhere in sight
and the few high profile figures that are questioning the fortitude of the US
economy are coming under fire as alarmists or having an ulterior motive. We do
not believe that we are headed for a recession but do want to prepare for the
worst case scenario.
As reported on CNBC,
“U.S. industrial production saw its
sharpest decline in more than three and a half years in November as utilities
dropped sharply, a sign of weakness that could moderate fourth-quarter growth.
Industrial output slipped 0.6 percent after a downwardly revised 0.4 percent
dip in October, the Federal Reserve said on Wednesday, marking the third
straight month of declines. Economists polled by Reuters had forecast
industrial production slipping 0.1 percent last month.”
While manufacturing is a smaller component of our economy
than in the past, we still place great importance on this figure as a gauge of
economic health. The following is from Seeking
Alpha and they write, “One note of
caution is the industrial production report this morning. The report shows the
first year-over-year decline since the end of the last recession. As the below
chart shows, a negative reading on industrial production nearly always occurs
around recessionary periods.”
The stock market is the ultimate in leading indicators. At
the start of the last two bear markets we saw Industrial Production
year-over-year start a precipitous decline as the stock market started rolling
over. The graphic below shows that when the S&P 500 breaks the 20 month
moving average to the downside, rises back to retest and fails, it hasn’t been
a pleasant outcome for stocks. Take a look at the actions of the y-o-y
Industrial Production during those periods and look where we are today. The
similarities are apparent and at the start of those bear markets, there were
not many economists calling for an outright recession. The case I’m making is
that recessions take hold before anyone really understands that we are in one.
I don’t think it’s that implausible that a recession could be looming somewhere
in the near-future that is unanticipated currently.
More on the Economy
From Business
Insider last week, “The latest report
on manufacturing from the Philadelphia Fed was a big miss. The latest index
came in at -5.9, indicating contraction in activity in the region. Expectations
were for the report to show the index hit 1.0, which would've indicated a
slight improvement in condition during the month of December.
According to the Fed's
report:
"Manufacturing
conditions in the region weakened this month ... The indicator for general
activity, which was slightly positive last month, fell into negative territory.
The indexes for new orders and shipments were mixed. Firms reported slight
increases in overall employment this month and an increase in average work
hours compared with November. Manufactured goods prices, as well as input
prices, declined this month. Nearly all of the survey’s future indicators
showed notable weakening this month."
This marks the third
time in the last four months that this index has been in negative territory.”
This is another item I track as it has shown to be the most
accurate of fed surveys.
From Business
Insider, “The Philadelphia Federal
Reserve's index of manufacturing activity is the best gauge of economic growth.
In their US Economics Weekly note, Bank of America Merrill Lynch (BAML)
economists highlight recent research that examines which indicators are best
for "nowcasting" models of gross domestic product, the quarterly
arbiter of economic growth…The research also found that the jobs report was the
top market-moving indicator, followed by retail sales. But for forecasting
whether the economy actually grew or not, look to the Philadelphia Fed index.”
The graphic below shows how this survey has been faring of
late.
2016 Headwinds
The graphic below is one that I display frequently on this
blog. If the market continues its topping behavior we believe most of the gains
for 2016 will be on the short side.
Bottom Line: We have
not lost faith for a year-end bounce in the market if the 2000 level holds. If
we decidedly break that level to the downside we will rethink our near-term
strategy. As far as our 2016 outlook, we are seeing disturbing economic and
earnings trends as well as unsettling market trends. If the bulls don’t regain
control of the market at this critical juncture, we believe most of the money
made in the market for 2016 will be on the short side of trades. As for an
economic recession, we don’t anticipate one but will be vigilant in our
investment thesis should things deteriorate further.
Joseph S. Kalinowski, CFA
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.com
Twitter: @jskalinowski
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