Finance, Insights

It Is All About Oil

PaulNolte-2The boomerang that we thought we had tossed away years ago is flying back to us very quickly. The Iraq “problem” was supposed to have been solved with elections beginning in 2005, following the military deposition of Saddam Hussein. Now with Sunni militants capturing two cities in Iraq, it looks as though the fire is once again burning in the Middle East. Pushing energy prices higher and worrying investors, this is but the last in a very long line of “issues” that the markets have been dealing with since the start of the year. From Russian aggression to the polar vortex’s impact on the economy to the Fed cutting back the involvement in the bond market, investors have already been through a firestorm in five short months. That the stock market is within a percentage point or two of all-time highs indicates the underlying strength in stocks. Whether believing there are no other investment alternatives or still wishing to ride the 2013 wave, investors remain willing buyers of stocks today. What event will turn back the bull market? Nothing that has hit the front page of the paper seems to be doing it. Our best guess remains signs of persistent economic weakness that has yet to show up in the
economic data.

June marks the beginning of the summer doldrums on Wall Street, when the denizens of trading desks up and down the street hit the beach for some R&R. Volume usually tails off during the summer; however this year’s decline is looking to be the largest in a few years. Just half way through June, volume is already trailing last year’s period by 20%. This is the fourth year in which volume has failed to surpass the prior year. While slow volume has been a concern, so too has the lack of volatility. Even with the big daily moves last week, the volatility index remains extremely low. History would tell investors that a low volume and low volatility periods should be sold. However it just may be that the steady increase in stock prices since late summer 2011 has lulled investors into just buying and holding. Why trade if any short-term decline will be erased by a future gain? Why trade if stocks “always” go up and any decline should be a buying opportunity? Why trade if we are indeed in a “new normal” where central banks “control” stock prices by their maintaining zero interest rates? Buy and hold will work until it doesn’t. Signs, as of now, don’t point to a change in the recent history.

Like stocks, the bond market has rallied on, keeping rates near their yearly lows as well. In the face of the Fed eventually eliminating their bond purchase program, many are left scratching their heads. Keys to the future direction of interest rates will be seen not just in the inflation data (which remains tame) or in commodity prices (which are only slightly above year ago levels), but in wage growth. Wage growth remains relatively modest and the recent pickup in gas pump prices may keep overall spending under wraps. Yields should not be rising dramatically over the coming months as little in the way of inflationary pressures are showing at this time.

The last time the energy sector was top of the industry group pile was in late 2010 until May ’11, after which the markets took a bit of a tumble. Prior to that, energy was top sector from mid-’07 until late ’08 as energy prices shot higher and preceded the huge market drop. Is energy leadership the precursor to a market decline? Of course energy was not a market leader in ’00, which was led by technology. But, surprisingly, energy was in the second spot for a few months late in ’99. Energy tends to be toward the “full recovery” part of the economic cycle and toward the end of the bull market cycle in stocks. So, given energy’s dominate performance in the past month, the markets may be in the eighth inning of the bull market. There has not yet been any deterioration in the market internals that would have us getting serious about reducing equity weights. As of today, we don’t see anything more than a short-term decline, but that can change with some weakness in the economic data. The FOMC has their regularly scheduled meeting this week, complete with comments from Fed Chief Yellen. Her take on the economy as well as that of the Fed will be important to put into the context of the recent gains in jobs data and a small tick higher in inflation.

The small decline last week in the markets seems to have more to do with the deterioration in Iraq that deterioration in the overall markets here. Equities are OK to hold onto at this time, but we’ll be watching for lackluster trading and a rotation toward the staples and away from energy as a sign that the markets have indeed peaked. Still way too early to tell based on the data today. Bonds may provide a short-term shelter while the equity markets gyrate over the coming few weeks.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.