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Market Outlook

Outlook: The Stock Market, Oil Prices and Monetary Policy

By Elliott H. Gue, on Jan. 26, 2016

Short but sharp rallies in the S&P 500 and other prominent equity indexes occur more often during periods of prevailing weakness than in the midst of a prolonged bull market.

Of the S&P 500’s 50 largest one-day rallies over the 20 years, 70 percent occurred during a bear market. In fact, 40 percent of these upsurges took place in 2008, the S&P 500’s worst year since 1931. And bear markets accounted for about half of the S&P 500’s biggest one-week rallies.

The October 2007 to March 2009 bear market is a good case study for investors. From the S&P 500’s intraday high on Oct. 11, 2007, to its intraday low on March 6, 2009, the index tumbled more than 57 percent. But this selloff didn’t occur in a straight line.

(Click graph to enlarge.)SPX 07-09

The S&P 500 rallied 8 percent in late 2007, surged 15 percent between March and May 2008, and rebounded almost 10 percent in July and August 2008. But these temporary rallies didn’t stop the S&P 500 from hitting a series of lower lows and lower highs over this period.

We regard the rally at the end of last week as an oversold bounce within the midst of a bear market—a blip, not an inflection point.

Last Wednesday, the S&P 500 sank to 1,812.29, breaching the support level at its August 2015 low and (by a smaller margin) the October 2014 low.

All told, the S&P 500 had given up more than 11 percent of its value as of its Jan. 20 low—the index’s worst start to a new year in history.

Small-capitalization stocks have performed even worse through Jan. 20, with the Russell 2000 Index down more than 26 percent from its high in June 2015.

Widespread panic among investors often marks a bottom. The Chicago Board Options Exchange S&P 500 Volatility Index (VIX) measures the volatility priced into the options market.

The VIX surged to an intraday high of 53.29 during last summer’s flash crash, well above its three-year average of 16. Last Wednesday, the VIX topped 32, suggesting that the market may have reached a temporary bottom.

Meanwhile, the number of stocks listed on the New York Stock Exchange that hit a new 52-week low jumped to 1,261 last Wednesday, slightly higher than the 1,154 equities that achieved this dubious distinction during the August 2015 flash crash.

With these key technical indicators stretched to the downside and the S&P 500 trading near its October 2014 low, the oversold bounce that occurred late last week hardly comes as a surprise.

The mainstream financial media attributed last week’s rally and yesterday’s downdraft in the S&P 500 to weak oil prices.

Oil Prices and the Economy

If you work in the financial infotainment industry and need to explain the move in a particular market, just hunt for another widely watched asset class that headed in the same (or even the opposite) direction during that trading session. No need to do any additional digging to understand the drivers behind a particular move. Correlation is causation in the world of infotainment—and you get an early start on happy hour.

The S&P 500’s rally late last week may have coincided with the rebound in oil prices, but the drivers (mostly technical) behind the move in equities are distinct from the dynamics in the commodity market.

After giving up more than 40 percent of its value since Thanksgiving 2015, West Texas Intermediate (WTI) crude oil was due for a short squeeze.

Data from the Commodity Futures Trading Commission (CFTC) show that as of Jan. 12, hedge funds’ aggregate reported short positions in WTI futures had reached a record 201 million barrels—up from about 90 million barrels in mid-October.

To turn paper profits into real gains, hedge funds must buy oil futures to cover their short positions. Over the seven days ended Jan. 19, hedge funds’ aggregate reported short position declined by 16.8 million barrels to 184 million barrels. The sharp rally in WTI prices late last week suggests that hedge funds likely pared their short positions even more; we’ll find out when the CFTC releases updated data on Jan. 26.

Although hedge funds have reduced their short positions, they haven’t increased their bets on upside in oil prices; gross long positions in WTI futures also fell by almost 4.6 million barrels.

Although this wave of short covering could continue sporadically for another week or two, the market won’t be able to ignore the ongoing build in global oil inventories during this period of seasonally weak demand.

Excluding the federal government’s strategic petroleum reserve, US crude-oil stockpiles remain 22.5 percent above their five-year average and likely will reach a record high over the next few months. Gasoline inventories have also hit elevated levels after soaring by almost 25 million barrels since late December 2015.

Given the US and global supply overhang, the assertion that another round of stimulus in Europe or China would provoke enough of a demand response to cure the oil glut is wishful thinking at best.

Our outlook continues to call for WTI to slip to between $20 and $25 per barrel in the first quarter, a price point that could prompt US producers to shut in some wells, stemming the flow of oil into storage. A sharp downdraft in spot and front-month WTI prices would also make storing crude oil in offshore tankers an option.

Our lower-for-longer scenario, where WTI ranges from $40 to $60 per barrel, will require a meaningful decline in global supply to balance the market. This rollover could start to manifest itself in the second half of the year, as two consecutive years’ worth of upstream spending cuts start to take their toll.

Moreover, lower oil prices provided one of the few upside drivers for the US economy and stock market last year. Although the S&P 500 finished 2015 with a paltry 1.37 percent total return, the consumer discretionary portion of the index—the sector with the most leverage to consumer spending—surged 8.4 percent.

Despite the big selloff in WTI prices so far in 2016, the S&P 500 Consumer Discretionary Index is down in line with the rest of the market. This poor performance, coupled with disappointing retail sales in December 2015, suggests that the last pillar of support for the US economy—consumer spending—has started to crack. Perhaps the stimulatory effect of lower energy prices has started to fade.

Evergreen 2015

The Path to Intervention

The European Central Bank (ECB) and authorities in Beijing likely will take additional steps to stimulate economic growth in 2016. The ECB, for example, could upsize its bond-buying program and/or reduce the deposit rate after its March meeting.

Recent market turmoil and concerns about the strength of the US economy may prevent the Federal Reserve from increasing the benchmark interest rate in March 2016; the futures market has priced in a roughly 32 percent chance of another hike—down from more than 50 percent at the end of last year.

But this outlook likely had little to do with last week’s rally in stocks.

The consensus outlook has called for the ECB to loosen monetary policy for at least six months; after the central bank failed to expand its quantitative easing program in December, global equity markets sold off sharply.

Even if ECB President Mario Draghi were to announce “a big bang” stimulus plan in March, the news may not be enough to pull the market out if its current funk—monetary policy hasn’t exerted the same effect as it did a few years ago.

Chinese equities would likely jump if Beijing were to announce additional measures to stimulate the economy, but the laundry list of actions authorities have taken thus far hasn’t helped to shore up investor confidence.

Finally, the Federal Reserve faces a conundrum. With the US economy stalling and the inflation rate well below the Fed’s mandated target of 2 percent, the central bank will struggle to meet its guidance for four rate hikes over the coming year. But pausing these rate increases would undermine the central bank’s credibility; policymakers have emphasized the US economy’s strength and the transitory nature of the recent weakness in inflation.

Not following through with its plan to tighten monetary policy could convince the markets that the Fed doesn’t have a handle on the situation or has run out of effective tools to stimulate growth. Either scenario would be bad for US equities.

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