Why are stocks selling off when economists tell us declining oil prices are wonderful? Answer: full valuations, investor complacency, financial blow-ups from plunging oil prices, and fears of global deflation.
Investor Complacency
A couple of years ago you could still find some bears in the Barron’s survey of stock market strategists. No longer. They are all fairly bullish on both earnings and valuation, expecting 2015 SPX EPS of $127 (too high by about $3.00 given the drop in oil prices) and a trailing PE at year-end 2015 of 17.5x (versus 16.2x in the middle of the last cycle, i.e., Q1 2005-Q2 2007). Strategists’ average year-end 2015 target is 2200.
Another sign of complacency is investor positioning. According to the WSJ, the number of trades handled by TD Ameritrade climbed 14% in the year ending September 2014. E*Trade’s margin loans outstanding climbed 31% in the past year; at Schwab they climbed 20%.
Lower Oil Prices: Good for Consumers, Bad for Speculators
In retrospect, it is clear oil prices collapsed due to weak global growth (see below), increasing energy efficiency, and abundant new supply. But that’s all hindsight. From January 2012 to July 2014 the XLE rose 37%, and many investors expected the strength to continue. They snapped up energy-related junk bonds, which comprise 16% of the High Yield Index. Now speculators are scrambling to sell stocks and bonds in markets made less liquid by Dodd Frank.
Weak Global Growth
Much of this selling has little to do with longer-term economic prospects. That said, there is enough bad news to convince skittish investors that weak oil prices show global growth is grinding to a halt, despite obvious strength in the U.S. (see Q3 earnings, Q2 and Q3 GDP, employment, retail sales, industrial production). The gloomy global trends:
- Europe is barely growing, due to a dysfunctional Euro-land; structural flaws in Italy and France; weak demographics; stagnant export markets; and Germany’s allergy to fiscal stimulus.
- Japan is stagnant despite a weak Yen and super-stimulative monetary policy.
- China is slowing sharply as its credit-fed real estate / infrastructure boom fades. Debating 7.4% versus 7.1% growth is absurd; try 5%.
- Many emerging markets (e.g. Russia, Nigeria, Brazil, Argentina, Venezuela) are weak due to mismanagement, weak commodity prices, and a strong dollar that hikes the burden of dollar-denominated debt.
Can the U.S. “Decouple?”– Lessons from 1998
I hear commentators opine the U.S. cannot decouple from economic weakness in the Rest of the World. This is largely false, as recent trends attest. Exports will be hurt by weak demand and a strong dollar, and domestic commodity producers will struggle. That will certainly take a toll on S&P profits, which are nominal. However, domestic demand is healthy and low inflation means a lower GDP deflator—both positive for real GDP. A Republican Congress is a plus for business confidence. And it’s positive to “rebalance” the U.S. economy by slowing the oil booms in Texas and North Dakota (booms inevitably lead to inefficiencies) while other regions benefit from low energy prices.
In 1998 S&P profits rose at just a low-single pace, due to global deflation and Russian default. (Oil prices dropped 55% in the two years ending December 1998.) However, U.S. real GDP rose 4.4% in 1998 and stock prices were strong (albeit very volatile). So I think the U.S. can grow nicely next year. And don’t forget that a strong dollar will boost growth somewhat in Europe and Japan.
Deflationary Tremors Will Weigh on U.S. Equities
Obviously the market shocks from plunging energy prices will precede the longer-term benefit. Currently we have a negative feed-back loop where investors interpret lower energy prices as bearish evidence of global deflation rather than the bullish result of improving oil field technology. With Russia raising rates to 17% to defend the Rouble the bad news is far from over; recall that a Russian default sparked the financial panic of October 1998, when Lehman Brothers had a near-death experience.
We have yet to see the full financial damage caused by weak oil for companies, banks, hedge funds, and countries. Who will take a hit if Russia or Venezuela defaults? (On a more bullish note, tougher regulation means Wall Street is far less financially over-extended than in 1997-98 when banks were competing to see who could lend the most to the wunderkinds at Long Term Capital Management, the giant hedge fund that blew up in the autumn of 1998.)
Make a List and Check It Twice
The first potentially positive signpost for equity investors will come in the second half of January when Q4 earnings results are released. Analysts will likely slash their 2015 estimates for energy companies when they hear grim guidance. On the other hand, analysts will also raise estimates for many weak-oil winners. Now is the time to make a shopping list of high quality domestic companies that stand to benefit from cheap energy via lower costs and/or stronger consumer spending. It is too early to bottom-fish among the “losers” because there is more bad news to come.
Copyright Thomas Doerflinger 2014. All Rights Reserved
