Oil Falls, Dollar Rises, Stocks Get Confused

“Reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.” George Soros.

As we come close to the end of a volatile year in stocks, one sudden an unexpected development (for some surely it was expected) slowed down the pace of a typical Santa Claus rally, it caused a shallow pull back, and raised a lot of questions. Crude oil price’s sharp decline caught many investors off guard and the confusion increased volatility.

Meanwhile, the dollar’s rise is also raising eye brows and questions (this is especially entertaining as I remember reading and listening the experts arguing over a crash in dollar’s value during the years following 2009). These two macro level trends create their winners and losers, and their impact is so huge, I wanted to clear some of the confusion and discuss pros and cons of each of them.

Also in this market update, as promised, I will go back to the list of indicators outlined in the previous market update, to help us objectively monitor the direction of the markets.

I picked the above George Soros quote because more often than not, the stock market makes no sense, at least in the short term. Eventually, things settle down but markets can and do stay irrational longer than investors can remain solvent. The reaction to the oil and the dollar price movements is no different, confirming Soros’ conviction.

Oil

Let’s start with oil. Oil is a commodity, which means its price is determined by the global supply and demand, and once set, it’s the same price everywhere you go. So the crude prices fell because there is a glut of it, exceeding the demand. The US is now the largest oil producer along with the Saudis. Shale oil and fracking technologies opened up global reserves twice the size of crude. This is so significant that it’s worth a pause here: the world’s known crude oil reserves are 1.7 trillion barrels, while shale oil reserves are 3.3 trillion barrels, of which 2.6 trillion is in the US. In other words, the US has more shale oil than the rest of the world has crude! How about that?

On the demand front, the Chinese economic growth rate of 8-9% is starting to look like a thing of the past. The world is adjusting to a growth rate of 6-7% in China, which implies less demand for oil. Europe is also not doing so well, neither is Japan, so there is lower demand for oil. Also, here is something for those who would like me to be a more creative. Over the past couple of years, Putin’s Russia has grown to be a more bold, wealthy and aggressive country, not shying away from threatening Europeans of cutting off their natural gas. The drop in oil prices is an enormously effective economic sanction policy as Russia heavily relies on energy exports. So one can speculate: Is Putin being “put in his place”? Clearly, the Russian elite are shaken, which is the only force that can pose a threat to him.

So how do these developments affect you or your investments? Why is the stock market falling along with oil prices? Stocks are falling, because the market is confused and tending toward disequilibrium. The stock market is pricing the scenario in which the falling oil price is due to a slowing down world economy. Partially this is correct, but it doesn’t factor in the benefits of lower oil prices, such as more money in consumers’ pockets, lower input prices and inflation, lower interest rates and less pressure on the FED to increase rates. So in net, it is good for the US consumer, an economy which relies 70% on consumer expenditures. So it should be a good thing for the stocks, also right? Yes and once this is realized, it will be a tail wind for stocks.

Dollar

The US dollar’s uptrend can also be explained by the supply and demand to it. Everywhere you look whether it is China, Japan or Europe, you’ll find accommodating central banks opening their can of quantitative easing packages. They do this to stimulate economic growth, keep rates low, turn cash into thrash, escape deflation trap etc. Rings a bell? As the whole world is drinking the FED’s cool aid, FED is (finally) saying enough is enough. This divergence in central bank policies will raise interest rates in the US, make its securities more attractive, bring foreign investors and push the dollar up.

Just like falling oil prices, rising dollar is also a net gain event. Yes it makes exports more expensive and less competitive, but import prices go down, helps keep rates lower, taking the pressure off of the FED to increase rates, encourages bringing production back to the US, improving the consumers’ purchasing power. A stronger dollar by definition means relatively cheaper Euro, Yen and Yuan, which gives Europe, Japan and China a competitive advantage over the US in the global markets, hence the “currency wars” being back in the headlines. This advantage may translate into better performance overseas in 2015, which for diversified investors is welcome news as in 2014, international stocks have lagged significantly.

Naturally, these moves create winners and losers; for instance, companies that heavily rely on exports may find their margins squeezed, while energy stocks may feel the heat but overall, a net gain for the US consumer, is a net gain for the US economy and the investor. As for the losers, my biggest concern is a contagion created by troubled Russian banks and a banking crisis in Europe. For now, this is a low probability event, but almost all financial crises seem to be so, prior to becoming obvious.

Let’s now move on to the market watch indicators, but first refresh our memories, my select list is:

Investor and trader sentiment, technical readings and seasonality, valuations, breadth, cash ratios, volatility, economic indicators and demographics, FED, political risks, interest and inflation rates.

Since we have been discussing currency, interest rates and central banks, let’s follow the theme and take a look at FED’s policy.

The FED

March of 2015 will mark the end of the sixth year of the US equity bull market, which has been driven by FED’s policies. Now that the monthly bond buying program is officially over, can this tip the scale so much that bears get their day under the sun? I don’t think so. The US economy is growing moderately, the inflation rate is below the 2% target, and wage growth is still lagging and exposing the recovery’s Achilles’ heel. The FED doesn’t want to slow down the housing recovery, so while raising short term rates, it will aim keeping long term rates the same (flattening the yield curve), and keep mortgage rates low. In other words, just because FED has stopped the bond purchasing program, doesn’t mean it is out of the accommodating game all together, and if the last six years have thought us anything, it’s this ; DON’T FIGHT THE FED. So long as the FED is not tightening, which will be driven most likely by inflation rate peaking its head above the 2% target, its policies will be a positive for the market.

Economic Indicators and Demographics

To summarize, this can be said: the US economy is growing moderately and demographics are favorable. Today (12.23.14) third quarter 2014 gross domestic product growth rate came in at 5%, which is the fastest growth since the third quarter of 2003. So it is extremely difficult to argue in favor of a recession. As for demographics, the largest age group in the US is millennials, or generation Y; those born (roughly) between 1980 and 2000. The significance of this is that these folks are stepping in to their highest spending years in 2015 (please note that these figures are reported differently by different analysts, so there is some room for subjectivity here). The US economy will have a tailwind as a result of this for the next 15 years. Granted, some of the effects will be offset by the mega baby boomers retiring trend, but in net, this is a positive. So, two out of ten indicators are so far, favorable.

Let’s leave it here for now and pick up where we’ve left off in the next market letter. In it, I will also dust off my crystal ball and include 2015 projections.

I wish you all Happy Holidays and a great New Year.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.