December 14th, 2014
by Jeff Miller, A Dash of Insight
Sometimes a dominant story continues from one week to the next. Crashing energy prices and continued selling of any related stock seems to have spilled over into the rest of the market. There will also be a Fed meeting with new projections and a press conference.
Will crashing energy prices change the Fed's course?
Prior Theme Recap
In my last WTWA I predicted plenty of discussion about a Santa Claus rally. It was indeed a popular subject, including some of those new live polls of TV viewers, but the story faded late in the week. It is a good thing I put a question mark in the title!
Here is Doug Short's weekly snapshot (with plenty of additional interesting charts in the post).
Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.
This Week's Theme
The decline in oil prices has been swift and sharp. Last week the selling clearly spilled over into other sectors, grabbing the attention of everyone. This relationship is the subject of considerable debate. It is happening on the verge of the FMOC meeting. Since the Fed remains a focal point for market analysts, I expect these two themes to converge:
Will crashing energy prices change the Fed's course?
The combination of the two requires analysis of each.
What does the oil price decline tell us about the economy (and therefore the stock market)? Here are the contending viewpoints:
- Oil prices are a good economic indicator.
- Declining prices imply a serious decline in the global economy (Mainstream media - typical example)
- This decline may drag down the US economy as well (perhaps via junk bonds- extensive analysis from Yves Smith) (earnings analysis from Brian Gilmartin)
- Other stock sectors will trade in sync with energy (investment spending cutbacks could ripple - Oil and Energy Insider)
- Oil prices have a complex and varying relationship with other economic indicators
- Declining oil prices have a mostly positive effect on the economy (Dr. Ed on the IMF upgrade of the US)
- Prices often move in a coincident rather than a leading fashion
- In 2008, high prices helped to create the recession, so oil was a contrary indicator
- In 2011, high prices reflected (inaccurate) QE speculation about inflation. The subsequent decline gave a false signal on the economy.
What will the Fed do as a result? Once again, we have dueling arguments:
- The Fed is poised to do another round of QE
- A deflationary threat will spark a dovish shift in policy
- The Fed acts to protect stock prices
- The Fed will react more to economic data
- This means eliminating the "extended time" before the first rate hike language, perhaps with a weaker substitute
- There may be more hawkish dissents
- The Fed will keep current policy and language, reacting to the lower risk of inflation
At the risk of oversimplifying, the "trader" community emphasizes the signal from oil prices. Bespoke has a good analysis with plenty of charts. Here is a key quote and one example:
The drop in oil is finally getting noticed by the market. Shocks to the system like this are not met with enthusiasm by investors, regardless of whether or not falling oil prices may ultimately be good for the economy. For now, it looks like oil is going to need to stabilize for the market to remain in rally mode.
The "economist" community, including economists at major street firms, emphasizes economic data.
Tim Duy is the leading Fed watcher. He believes that economic data support the Fed plan already telegraphed. Read the full article for plenty of supporting argument, data, and charts.
The "investment" community takes a long-term, data-based viewpoint.
Josh Brown is a vocal representative for this group, and argued forcefully both on TV and his blog - They're all making it up. In a refreshing look at actual data, he notes that oil prices frequently show a negative correlation with stocks. His conclusion:
They're watching market prices fluctuate and assigning meaning where none exists. Stories are being told and headlines are being crafted so that there is something for you to click on from your app when you check the news. This is nothing to be mad about, it is what it is. But the sooner you learn this lesson, the savvier a consumer of financial news you will be.
Daily market reports - collections of statistics woven together with quotations from whichever experts answered their phones - are inferior to raw data and charts. They're giving you an ex-post description of the beliefs of your fellow guessers who are no better at explaining day-to-day randomness than you are.
I read that book and you should, too. You will both enjoy and learn.
I have some strong opinions on this question, with implications for investments. More about that in today's conclusion. But first, let us do our regular update of the last week's news and data. Readers, especially those new to this series, will benefit from reading the background information.
Last Week's Data
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially - no politics.
- It is better than expectations.
The news last week was very good, once again positive, despite the market reaction.
- Hotel occupancy is stronger. The rate is up over 3% year over year, to a current level of 57.1% Calculated Risk has the story on yet another non-government data source showing economic strength.
- Consumer confidence hit another new high - almost 94. This is a good proxy for spending, employment and stock prices.
- Job openings show strength. The JOLTS report does not get enough respect. I was an early follower and recommended the quit rate as the best takeaway. See this post from 2009. This indicator has finally arrived, since it was featured by USA Today! There is finally some understanding that voluntary separations indicate confidence and labor market strength. How many people realize that 2.8 million people voluntarily quit their jobs in September? That is the point of this report - not an inferior, back-door method for estimating net job growth. Here is an authoritative story from Calculated Risk - job openings up 21% year-over-year.
- Retail sales showed strong growth - up 0.7% month over month and 0.9% without gasoline. (Remember that many chose to dismiss strong retail sales in some prior months since it reflected only gas prices. Let us be fair in analyzing this). New Deal Democrat sees this as solid evidence of improvement for the consumer, citing the chart below. (Doug Short is more skeptical, noting the big revisions in this series).
Once again, the bad news was less significant than the reaction in stocks. Readers are invited to nominate ideas in the comments, but remember that we are focusing on recent developments, not a list of continuing macro concerns. Art Cashin had (yet another) good quip this week about people who had a cup of coffee and "suddenly noticed" something. I share his skepticism about delayed reactions.
- Chinese economic news disappointed. Rules for investing were changed to eliminate low-grade corporate bonds as a source of collateral. Some likened this to a US increase in the margin requirement. There was an immediate 5% hit to the high-flying Shanghai Composite. Did you know that the Chinese have a 35% savings rate? Dr. Ed has the story, and this chart showing the slowing Chinese imports:
- Europe. For those who believe in spillover effects, the European story was very negative. There was negative news from both Greece and France.
Stocks - the worst week in four years.
Congress is on probation. Temporary action seems to have averted a government shutdown, but only for a few days. (Politico and The Hill on the House compromise). It appears that a final resolution will be reached in the Senate by Wednesday, but it remains a worry. Some attributed part of Thursday's late-day selling to the failure of a compromise bill. (Politico) I continue to watch closely.
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger. No award this week. Nominations welcome.
Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.
Recent Expert Commentary on Recession Odds and Market Trends
Georg Vrba: has developed an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. Georg's BCI index also shows no recession in sight. Georg continues to develop new tools for market analysis and timing. Some investors will be interested in his recommendations for dynamic asset allocation of Vanguard funds. Georg has a new method for TIAA-CREF asset allocation. I am following his results and methods with great interest.
Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured "C Score."
RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting market indicators.
Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (three years after their recession call), you should be reading this carefully.
It is time for another update to Doug's Big Four - the indicators most important to the official recession-dating process.
Healthy skepticism on seasonality comes from Statistical Ideas (A special HT to Abnormal Returns). A better look at Santa and also years ending in "5? Really?
The Week Ahead
There is a normal data schedule this week, with emphasis on the Fed meeting.
The "A List" includes the following:
- FOMC decision (W). Announcement, dot plots, press conference and more.
- Initial jobless claims (Th). The best concurrent news on employment trends, with emphasis on job losses.
- Housing starts and building permits (T). I emphasize permits as a good leading indicator for housing.
- Leading indicators (F). Will the recent strength continue?
The "B List" includes the following:
- CPI (W). Not yet a major concern, but still watched carefully.
- Industrial production and capacity utilization (M). A rebound in this volatile series?
- Crude oil inventories (W). For the moment at least, this announcement is getting plenty of attention.
I do not care much about the Empire Index or the Philly Fed, which had an amazing reading of 40.8 last month. Everyone was skeptical of the data, so the reaction this week should be interesting. FedSpeak is on hold before the meeting. Richmond President Lacker is scheduled for Friday, which could be interesting. So is IMF chief Lagarde.
How to Use the Weekly Data Updates
In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a "one size fits all" approach.
To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?
My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.
Insight for Traders
Felix continued the profitable bullish posture for another week. There is still reasonable breadth among the strongest sectors, although the ratings continue to decline. The overall average strength is now neutral, so this week's "bullish" call is a close one. Felix does not anticipate tops and bottoms, but responds pretty quickly when there is evidence of a change. The penalty box can be triggered by extremely high volatility and volume. It is similar to a trading stop, but not based only on price. There has been quite a bit of shifting at the top, so we have done some trading.
Dana Lyons has a short term indicator that has never failed! (So far). The pop in VIX is bullish for the year-end.
Andrew Thrasher warns that being "overbought or oversold" is often not enough. Traders should check out his charts.
You can sign up for Felix's weekly ratings updates via email to etf at newarc dot com.
Insight for Investors
I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are directed at spotting these major declines. A key element is staying focused on data rather than noise. I took a closer look at the most recent scary themes in Keeping Investors Scared Witless. If you missed it, please take a look.
Last week I also offered Some Crucial Facts about Energy, providing some perspective on the oil price decline and associated opportunities.
Here is our collection of great investor advice for this week:
Mark Hulbert suggests that stocks are "not even close" to topping out. The main thesis is that sentiment is far different from what is usually seen at market tops.
The Fat Pitch has a different take, citing data both from individual investors and the opinions of Barron's Wall Street Strategists.
Scott Grannis likes junk bonds, based upon current swap spreads. I recommend buying with care if you are looking at individual bonds in the energy sector.
The opportunities and risks of MLP's. All About Alpha has a comprehensive analysis of risks and rewards.
Growth stock suggestions from Barron's - including one in energy.
Ray Merola has some "energy gems among the rubble."