If you had not checked the financial section of a paper since December 5 of this month, you would think the market had gone nowhere. On that day, the Standard and Poors 500 Index closed sat 2,075. Last Friday, December 19, 2014 it was 2,070.
During that two-week period, the index went as low as 1,972 on December 16, 2014 before recovering all but five points in the ensuing three days. The market did almost the same thing in October, when the index fell from 1,968 on October 8, 2014 to 1,862 on October 15, 2014 recovering to 1,964 on October 24, 2014 and continuing to go up from there.
What do these sudden price changes mean? The glib answer is, “more buyers than sellers”, or vice-versa. It also speaks of the legions of speculators, both amateur and professional, who try to trade off the market’s direction. According to the data, their track record as a group is not good. According to people quoted in various investment publications, hedge funds are at breakeven so far this year, with some showing significant losses from their market bets.
While the track record of short-term traders is not good, their influence on trading, in the short term, is very real. Estimates of the volume of short-term trading to total trading volume are as high as 40 percent. Such estimates, if valid, help to explain why such trading is tolerated by stock exchanges and brokerages, even when it makes investors’ portfolios so volatile. There has to be a lot of money in it.
For the investor, such market “noise” is a source of frustration. How can the value of securities fluctuate so much in such a short time? After all, it is not as if the value of the companies has changed as much as the price swings of the past two or three weeks.
The answer has two parts. For some stocks, such as the ones associated with the energy sector, there have been changes since November 28, when OPEC decided not to reduce output to support the price of oil. In essence, the market has valued upward the firms that use oil, such as airlines, railroads, and other forms of transportation. Also benefitting are consumer stocks, on the rationale that consumer spending will increase with lower energy prices. At the same time, the companies associated with the oil industry have been sharply reduced, often indiscriminately. For example, the price of
natural gas has remained steady in the past month, but gas stocks have been marked down with the oil issues.
For other companies, there has not been a significant change, but their stock prices have still been pulled along with the ebb and flow of the market. Some of this is due to people trying to time the market by buying index funds. As they bail due to some mechanical rule such as, “sell when the price declines five percent”, they bailed at the bottom of the last two pull-backs. No doubt they will bail again. Without knowing what they own or in what proportion, they lack the conviction of those investors who invest in individual companies. As such, their panic creates buying opportunities for the better informed.
In this most recent retreat, income investors have been especially hard hit. Energy investments have constituted the bulk of income opportunities for the past couple of years. However, even here, the distance between reason and hysteria is rather great. In most cases, the cash flows from the investments have not been impacted. Some will be, but many will not. Given the alternative of Treasury investments that yield two percent out to ten years, and three percent out to thirty, the alternative is slow erosion to inflation and taxation.
Even the decline in energy prices will not be permanent. The world consumes roughly 92 million 42-gallon barrels of oil per day. It is estimated that a 2-3 percent increase would be all it would take to absorb the difference between supply and demand. Given global growth, this could be achieved in 12-24 months. Since the decline in price was more of an excess in supply than a reduction in demand, this fact bears watching. The last time oil declined like this was in 2008-09, but that was a demand contraction. This is the opposite.
In fact, the unwillingness of Saudi Arabia to reduce oil production has more political than economic overtones. There is no love lost between the Saudis and Iran, which needs higher oil prices to fund its nuclear program, as well as to finance its incursions into Syria and Lebanon. Russia, Iran’s ally, also needs high oil prices to carry out its military ambitions. It would be interesting to know if Cuba’s willingness to open its borders is because neither Russia nor Venezuela can afford to continue to subsidize it. If oil prices are being set politically, they may change for political and not economic reasons.
Economic numbers continue to improve. Unemployment claims are in decline, and consumers are buoyed by the increase in incomes due to the decline in oil prices.
There are expected to be declines in capital spending by energy companies, at least until the price of oil recovers. However, lower oil prices should make higher gasoline taxes more palatable, which will increase infrastructure spending.
Interest rates have been in sharp decline with the price of oil. This is in part due to the influx of foreign wealth seeking a safe haven in the US. It is also due to the ongoing decline in the federal deficit. This year the deficit is expected to be under $500 billion for the first time since the financial crisis in 2007. As the Federal Government borrows less and the economy expands, the percentage of debt to GDP will decline. This is considered a key metric for a country’s financial health. This ratio is slated to reverse itself later in the decade, as Social Security and Medicare programs cause the deficit to swell, even with a strong economy.
On the surface, inflation has had another reason not to increase with the decline in oil prices. This decline, especially in the form of gasoline, will act as a tax cut for most consumers, especially for those of more modest means.
With the increase in consumer spending afforded by the gasoline price reduction, the labor markets will be tested in terms of their ability to create workers to meet the incremental demand. There is some concern that the labor pool may not be as deep as some think. If this is the case, the incremental consumer demand may spark competition in wages in a way not seen since the 1990s.
The Stock Market
After all the gyrations, the market is up about ten percent year to date, The areas of greatest gains are in the large capitalization companies favored by index funds, and the transportation sector. Smaller companies and energy names have lagged thus far.
The trading for the next two weeks is expected to be light, and thus easily influenced. Not until the first full week of January is trading expected to return to normal levels.
As past is hardly prologue for investing, there will no doubt be new winners and losers in 2015. Companies with evolving strong fundamentals will be favored, while stocks that sell at a premium to the market, without premium growth prospects, will be vulnerable. There is an old saying on Wall Street: investors will pay a premium for predictability, until it is no longer predictable, or predictability is no longer a premium.
Warren M. Barnett, CFA December 22, 2014