Disparate Impact of Lower Oil Prices

January 10th, 2015
in contributors

Macro Strategy Report for January 2015

by Jim Welsh with David Martin and Jim O'Donnell , Forward Markets

Whenever a commodity as important as oil moves by more than 40% in a short period of time, there are likely to be repercussions no one can foretell with any certainty. What we can say with certainty is there will be surprises in 2015 and some of them won't be good.

Follow up:

The winners are easy to identify since the costs of living and doing business have just fallen materially for any consumer or business that uses oil or gasoline. This should be a net positive for global growth even after accounting for the reduction in capital investment in energy that will weigh on growth. For countries dependent on the sale of oil, however, the decline in revenue will capsize fiscal budgets, potentially forcing a reduction in energy subsidies, which consequently might incite riots or even a revolution in some countries.

Until producers agree to cut production, oil is likely to remain under $60 a barrel and potentially even fall to under $40 a barrel in the short run. In this game of chicken, those with the deepest pockets can afford to apply pressure on marginal producers until they are forced to cut production or get out of the game. Saudi Arabia had $737 billion in reserves as of August since in recent years it chose to save a portion of its annual oil revenues. This puts Saudi Arabia in a strong position relative to a number of other OPEC (Organization of the Petroleum Exporting Countries) members since it can finance current domestic government spending for three years.

Since June, oil prices have fallen from $107 a barrel to $54. Make no mistake: a significant increase in U.S. oil production is driving the decline. Technology has made it possible to extract more oil from shale rock, drill deeper in the Gulf of Mexico and tap more oil deposits through horizontal drilling techniques. The result of all this innovation is that domestic oil production is 8.9 million barrels a day, up from 4.7 million barrels a day in 2008. Although oil produced in the U.S., by law, cannot be exported, it has lowered our demand for imports from other countries like Nigeria, which has provided the U.S. oil for 41 years. While not long ago the U.S. was importing one million barrels of oil a day from Nigeria, in July 2014 it didn't import a single barrel. With no U.S. demand for Nigerian oil, Nigeria was forced to sell its oil to China, India and Indonesia, taking market share from other producers. The increase in global oil supplies initially forced more competition and price discounting to protect market share between oil producers. Gradually, the downward pressure on the price of oil increased and turned into a cascade when Saudi Arabia and fellow OPEC members couldn't agree to cut production.

This is a textbook example of how the law of supply and demand impacts prices. As production of oil increased in the U.S. over the past five years, the growth in supply incrementally rose faster than the growth in global demand. The price of oil will fall until a new equilibrium between supply and demand can be established. This may take longer than some expect since countries and companies dependent on oil revenue are likely to increase production to replace some of the lost revenue caused by the decline in the price of oil. In the U.S., companies that borrowed money to jump into the fracking business late have a higher cost of production than companies that were at the forefront of the fracking revolution. Those companies that borrowed money will likely choose to increase production to service their debt. This creates a paradox where one company increases production so it can avoid default, which leads to more supply and lower oil prices, which then pushes more companies to the brink and to the same decision. Ironically, the first company's decision to increase production winds up making it even more difficult for it to survive after other companies are forced to make the same decision. Another reason U.S. supply may increase in the short run is that halfway finished wells are likely to be completed rather than abandoned. As the finished wells come on stream, they will add to the supply of oil.

If oil remains below $60 a barrel for a prolonged period, the risk of negative surprises is likely to increase. Governments overly dependent on oil revenue to support government spending could be especially vulnerable. According to a recent analysis by Deutsche Bank, the "breakeven" levels per barrel of oil for the following countries are: Iran and Bahrain: over $130; Ecuador, Venezuela,Algeria and Nigeria: around $120; Libya: $110; Russia: $100; Angola and Saudi Arabia: $93; Oman, Kuwait, Qatar and U.A.E.: around $70. All of these countries will be tempted to increase production in an effort to generate more revenue, which could lead to a decline below $40 a barrel. Although most of these countries may have to confront some level of disequilibrium, the two countries that pose the greatest geopolitical risk are Iran and Russia.

In recent years, Iran has threatened to close the Strait of Hormuz in response to U.S. pressure on Iran's nuclear program. In January2013, Iran's ambassador to Iraq said Iran would have no qualms about closing the Strait of Hormuz; If Iran faced a "problem," it would be within its rights to "react and defend itself."1 Oil below$130 a barrel for an extended period is a serious problem for Iran and there is no certainty in how its leaders may respond to this problem. More than 20% of the global supply of oil flows through the Strait of Hormuz, so even a temporary disruption could cause a large rally in oil prices.

The last decade has been good for the average Russian citizen. Putin exerts almost total control over the news flow in Russia and the typical Russian citizen believes Putin's decision to take over Crimea and his support for the separatists in Ukraine is merely a response to aggression from the West, the U.S. in particular. They believe the Malaysian passenger jet was shot down not by the separatists but by NATO because that's what they have been told by their media and government. The Russian media says that NATO shot down the plane so it could blame the separatists and Russia for supplying the weapons. Russia's gross domestic product (GDP) may fall by more than 4% in 2015, but Putin's approval rating is over 70%. As the recession begins to affect the average Russian citizen next year,support for Putin will likely decline. When Putin's popularity wanes,the risk of Putin doing something "patriotic" will increase. In 1998,Russia defaulted on its loans, which led to a shakeout in global financial markets. We doubt he would take that action now, but he could threaten to stop making interest payments on the $670billion Russia owes to western banks and investors. Since the West imposed the sanctions and engineered the plunge in oil prices,according to Russian media, not paying interest on loans to western banks would seem like the right payback to the average Russian citizen and cause Putin's approval rating to rise.

There are 19 countries in the Middle East and North Africa that rely heavily on energy price subsidies to provide a social safety net and a form of income distribution for their citizens. According to the International Monetary Fund, subsidies provided by these countries totaled $237 billion in 2011 (the most recent data available). The average cost of one of these subsidies represents 22% of government revenue and 8.6% of GDP. In contrast, food subsidies amounted to just 0.7% of GDP on average in 2011. Oil represents about half of total energy subsidies, with the balance coming from electricity and natural gas. Subsidies benefit households directly through lower prices for energy used for cooking, heating, lighting and personal vehicles. These subsidies are highly inequitable,however, as they disproportionately go to those with incomes in the top half, yet any reduction has a far greater impact on the poor,who manage to survive on a few dollars of income a day. Large swings in the price of oil also subject the fiscal budgets of these countries to periods of big surpluses and deficits. Those countries that experience large fiscal and current account deficits when oil prices fall significantly are then vulnerable to capital outflows,which can cause a country's currency to fall and result in higher domestic inflation.

Countries dealing with a depreciating currency caused by large fiscal and current account deficits face a number of difficult choices. One option is to raise interest rates to stabilize their currency, as Russia recently did from 10.5% to 17.0%. Even if an interest rate hike is successful in stabilizing a country's currency in a free fall, large increases in interest rates often tip the domestic economy into recession, as Russia will experience in 2015. In order to lessen the strains from a fiscal and current account deficit, a country with a large energy subsidy may be forced to reduce that subsidy. Since energy consumes a much larger portion of income in poor countries, a lower subsidy can put an unbearable strain on the poor managing to survive on a few dollars a day. If a country lowers the subsidy too much, it risks riots and, in extreme cases, a possible revolution.

China and India will benefit from lower oil prices. China is the world's second largest net importer of oil, and each $1 decline saves China about $2 billion. If oil prices remain under $60 a barrel throughout 2015, China's bill for imported oil could be $80 to $100 billion lower. According to the World Bank, a dollar of farm output takes four to five times as much energy to produce as a dollar of manufactured goods. Since most of the world's farmers are poor,cheaper oil is a plus for poor countries. More than 30% of those who live on less than $1.25 a day live in India. Oil accounts for more than 3% of India's imports, so lower oil prices will improve its trade balance and lower India's rate of inflation. In early 2013, inflation was over 10%, but it has already fallen to 4.38% in November and is likely to fall more. Since India provides subsidies for energy, lower oil prices will also help it lower its budget deficit from the current level of 4.5% of GDP.

In 2013, imported oil cost the European Union (EU) almost $500billion. The EU could save more than $100 billion in 2015 if oil holds under $60 a barrel. The dark side of this good news is that outright deflation is likely to emerge in many EU countries in the first half of 2015, which will only heighten concerns about Japanese-style deflation taking hold. This is likely to increase pressure on the European Central Bank (ECB) to do more, while real change-such as a rewrite of labor laws in France and Italy-is ignored by politicians.Since the United States is the world's largest oil consumer,importer and producer, the impact of lower oil prices will be mixed. Consumers and energy-intensive industries are obvious beneficiaries of cheaper gas and oil, which is already understood by economists and priced into the markets. The downside is less obvious and will likely take longer to surface, potentially surprising those who currently only see the benefits. The development of shale oil lifted job growth materially in those states with large shale deposits: Texas, North Dakota, Pennsylvania, Colorado and West Virginia. There are now 1.3 million more jobs today in these five states than the prior peak in January 2008. Though certainly not all new jobs in those states were directly related to oil and gas producers and their suppliers, in many other states employment is still lower than January 2008. According to the U.S. Department of Labor, there are now 2.13 million more jobs than in January2008, so the new jobs resulting from oil and gas development clearly made a solid contribution for the country. Although 2.13million jobs since 2008 may sound like a decent amount, it works out to be less than 400,000 a year and, compared to every other recovery since World War II, is actually quite low. If adjusted for population growth and the current participation rate, job growth since January 2008 is more than 6 million jobs light, almost three times the number of jobs that were added. Speeches that reference this year being the best year for job growth since 1999 and tout the amazing consecutive strength of monthly job growth sidestep these inconvenient historical stats. If oil prices remain below $60a barrel for an extended time, job growth related to oil and gas development will flip from being a positive for the economy into a negative. Although the impact will be concentrated in these five states, with Texas being the most affected, the job loss from this once vibrant sector will dampen overall job growth in coming months.

As more companies rushed to cash in on the boom in shale oil development in the last four years, many firms used borrowed money to finance their operations. Since 2008, companies have issued almost $500 billion of junk bonds, which represents close to20% of the high yield bond market. Since oil prices began to trend lower after June, high yield bonds (junk bonds) have lost 8% of their value. According to Barclays, one third of the decline occurred in the first half of December, after the oil price slide accelerated.The spread between Treasury bonds and junk bonds has widened from 3.23% in June to 5.28% as of December 15. Commentators have referred to the surge in oil-related borrowing as a bubble,some comparing it to the subprime housing bubble that led us into the financial crisis. We think these views overstate the potential magnitude of the problem. Defaults will make headlines and prove disruptive, but they are unlikely to prove a systemic threat.

U.S. Economy

On April 28, the average national price for a gallon of gas was $3.60,according the American Automobile Association. As of December19, it was down to $2.39 a gallon and likely headed lower. According to Clearview Energy Partners, the average household could save over $380 over the next year while IHS Global Insight estimates the annual savings could be as much as $750. To put this into perspective, Sentier Research estimates that for the year between October 2013 and October 2014 real median household income increased by $554 to $53,713, or a 1.0% boost. Over the last four years, average hourly earnings have increased only 2.0% a year,which has barely been enough to keep up with inflation. During the average post-World War II recovery, earnings typically grew by more than 3.0% annually. While a sudden drop in gas prices is nice, a 3.0% pay raise would lift both gross and take-home pay and would be viewed as far more permanent. Consumers have seen this movie before and they know how it ends-sooner or later gas prices will go up again. Although their new found wealth is welcome (Christmas came early in 2014), consumers believe it is transitory. It is unlikely that Americans will spend all of the additional $10 to $15a week in new found wealth, but they will spend enough to give the economy a lift.

A few months ago we cited a Gallup poll that found that 47% of Americans thought the economy was still in recession. This poll reflected the fact that median income for half of U.S. households is lower than seven years ago. According to Sentier Research, real median income has increased 3.7% since August 2011, but is still down 3.4% from June 2009 and down 5.1% from $56,592 in December 2007. The extended stretch of tough times during this"recovery" has eroded American's faith in the future. According to a poll by the New York Times in early December, only 64% of respondents said they still believed in the American dream when asked, "Do you think it is possible to start out poor in this country,work hard and become rich?"2 This is remarkable since in early 2009,as the economy and financial markets were in free fall, 72% said they believed in the American dream.

Since the late 1960s, there has been an explosion of government regulation that has swelled the number of pages in the Federal Register from 20,000 per year to more than 70,000 per year since1997. We are not in the camp that thinks all regulation is bad, nor do we believe every regulation is necessary. We do believe there is a cost associated with every regulation that in some cases may outweigh the benefit to society. In the wake of the financial crisis, Dodd-Frank was passed to prevent another financial crisis from occurring. Though the bill was passed in 2010, there are still sections being written, so it is complicated. While institutions with more than $10 billion in assets can handle the increased regulatory cost burden, many community banks cannot. This has created an uneven playing field, which is all the more ironic since community banks had almost nothing to do with causing the financial crisis. We doubt the average American is aware of the impact of Dodd-Frank on community banks or the number of pages in the Federal Register. The New York Times poll cited previously also asked, "What do you think is the bigger problem in this country-overpopulation may interfere with economic growth or too little regulation that may create an unequal distribution of wealth?"3 Surprisingly,54% said overregulation was the bigger problem compared to 38% who said too little regulation was a problem. If this were an election, commentators would call it a landslide. Who knows,maybe concerns about too much regulation played a small role in the mid-term elections.

As we discussed in the July and September Macro Strategy Reviews(MSRs), the Thomson Reuters/University of Michigan Consumer Sentiment Index measures consumers' assessment of current economic conditions and their expectations for the next six to12 months. Over the past 35 years, the demarcation between economic growth and recession has been about 82 on the index.Between May and September of 2014, the index hovered near 82before jumping significantly during the last two months. From November to December, the index climbed from 88.8 to 93.6, the highest level since January 2007. The decline in gasoline has played a big role in boosting consumer confidence. It would be natural for optimism to slip a little after such a sizable jump in such a short time, but if the index can hold above 85 in coming months, it would remain an ongoing positive.

Over the last 30 years, the National Federation of Independent Business (NFIB) Optimism Index has confirmed an economic expansion when it has risen above 97.0. As of November 30, the index reached 98.1, up 2.0 points from October. Hopefully, the NFIB Optimism Index will rise further based on the continued decline in oil and gas prices during December. If it can hold above97.0 in coming months, it will help the economy offset the coming slowdown in exports due to the increase in the dollar and the drag from the energy sector.

Consumer confidence has also been boosted by better job growth in recent months. In November, 321,000 new jobs were created,which puts 2014 on pace to be the best year since 1999. Despite healthy job gains in 2014, average hourly earnings still only rose by 2.1% from a year ago. Hopes for better wage growth in coming months were kindled by a 0.4% increase in November from October.But as wage growth has been stuck near 2% annually for four years,a one month blip does not establish a new trend. Supervisors and managers received the bulk of the increase, so the gain was not spread across the majority of workers. According to a recent analysis by the Department of Labor, income growth between 2007 and2013 for the middle 60% of the population only registered a gain of0.5% while inflation rose 12%. Wage gains have come so sparingly that the middle class (the 60% making between $18,000 and$95,000) is thrilled to have a few extra bucks in their pocket from cheaper gas.

Monetary Policy and Business Investment

The Federal Reserve (Fed) has kept short-term interest rates barely above 0% for six years and has expanded its balance sheet from$900 billion in 2007 to $4.4 trillion in 2014 through quantitative easing (QE).  The suppression of interest rates and bond purchases by the Fed has made it possible for corporations to borrow cheaply.  Issuance of investment-grade and junk bonds has soared from $953billion in 2009 to $1.31 trillion in 2012, $1.41 trillion in 2013 and$1.39 trillion through November 2014. Borrowing at lower interest rates has saved corporate America several hundred billion dollars in interest expense in recent years, which is a good thing. However, an increasing number of companies have used debt to buy back their stock.  In the 12 months through the end of November, 374companies in the S&P 500 Index spent $567.2 billion on share buybacks, up 27% since November 2013. Over the last four years,corporations have spent more than $2.2 trillion on stock buybacks.Between 2003 and 2012, of the 449 companies publicly listed in the S&P 500, 54% of earnings were used to buy back stock and 37%were used to pay dividends.  According to Barclays, the proportion of cash flow used for stock buybacks has almost doubled over the last decade. With such a large percentage of earnings being used to buyback stock, the proportion of cash flow used for capital investments has declined. One driver behind the shift toward more stock buybacks has come from the increase in executive compensation derived from stock options and stock awards. In 2012, the 500highest-paid executives named in proxy statements of U.S. public companies received an average of $30.3 million. Of this total, 42%came from stock options and 41% from stock awards. What's more astonishing than the level of compensation is the obvious conflict of interest. Some executives recommend to their firm's board of directors that a better use of the company's earnings is buying back more stock, or worse, that they should borrow money for the buybacks. The fact that stock buybacks somewhat directly enrich executives is overlooked by the board, whose focus is supposedly on the long-term interests of the company. A mutual fund portfolio manager who buys a stock for his personal account before purchasing it for the fund runs afoul of security laws. A company, however, can buy its stock all day, every day based ona recommendation from the firm's executives to the board of directors and the Securities and Exchange Commission sees no conflict of interest.

Cheap money has incentivized companies to increase earnings by using more of their cash flow and borrowed money to reduce their share count through stock buybacks rather than investing in their business and future. In addition to skimming capital investments for buybacks, corporations have kept their hiring and wage increases to a bare minimum. On the surface this looks like a winning business plan since after-tax profits as a percentage of GDP are at an all-time high. But upon further review, there is a less promising message: employee compensation as a percentage of GDP has been trending lower for decades and is at the lowest level since record keeping began in 1947.

Earnings juiced by stock buybacks and financial engineering along with the suppression of wages and quality jobs may make the S&P 500's price-earnings (P/E) ratio appear reasonable. But these earnings are not the same quality of earnings derived from intelligent research and development (R&D) investment, new products and solid revenue growth. Henry Ford became famous for implementing the assembly line, which lowered the amount of time to build one car from 12 hours to just 93 minutes. The increase in the production of cars lowered the cost of each car produced,making them affordable. His real genius though may have been deciding to pay his workers enough so they could buy the cars his assembly lines produced.

We floated this idea of raising employee compensation in the January 2013 MSR and still think it is an interesting concept.Rather than buying back $567.2 billion in their stock in 2015 asthey did in 2014, public companies might consider, and be better served in the long run, if they gave all their employees earning between $30,000 and $70,000 a 5% pay increase. In total, it would cost the 500 companies in the S&P 500 around $450 billion, less than what they're spending on buybacks now. Think about this: if saving a few bucks at the gas pump can lift consumer confidence as much as it has, imagine what a 5% pay raise would accomplish.  It would certainly be good for the country, and the timing would be perfect since the Fed is patiently waiting to raise interest rates.  Who knows, maybe a 5% pay raise would kick-start demand and lead to more business investment since low rates during the last six years has not.


The next meeting of the ECB's governing council is on January  22 and has the potential to be contentious.  Germany has been opposing the ECB's purchase of sovereign bonds through quantitative easing. Interest rates on 10-year bonds in Germany are already below 0.60%, with Italian and Spanish yields below the 10-year U.S. Treasury yield.  Will buying sovereign bonds make an economic difference if QE manages to push yields just a little lower? Probably not.  However, yields are this low in Europe because European banks and investors have been buying sovereign bonds in expectation that the ECB will launch QE eventually.  If the ECB does not act, yields throughout Europe would likely rise, which would not be helpful. Inflation in November was just 0.3%, well below the ECB's target of 2.0%, and is likely to fall below 0% as the decline in energy works its way through the European economy incoming months.  With economic growth almost nonexistent, the pressure on the ECB to act is only going to intensify and may make Germany's opposition to QE untenable.

The operational challenge of implementing QE is far more complicated for the ECB than it was for the Fed or the Bank of Japan since they were purchasing just their own country's bonds. The ECB, on the other hand, must purchase bonds from 18 different countries, and this gets to another reason for Germany's opposition to QE.  The credit quality of sovereign bonds varies widely within the eurozone and buying Greek bonds exposes the ECB's balance sheet to more risk than German bunds.  This risk could be substantial if acountry decided to leave the euro, which is being actively discussed in Greece and three of Italy's four biggest political parties due to austerity measures.

The leverage on countries to adhere to the fiscal rules of the European Union would be lessened if sovereign bonds are purchased by the ECB and held on its balance sheet.  Recently France and Italy passed budgets that did not lower their budget deficits to 3% of GDP since support for austerity is waning.  Germany contends that keeping fiscal balances below 3% of GDPis good long-term economic policy and it does not want to see this leverage diminished. Thus, Germany prefers any bonds purchased be held on the balance sheet of each country.

However, if the bonds purchased through QE are held on the central bank balance sheet of each country, investors could be exposed if the national central bank decides in the future to pass on potential losses to investors.  Losses on bond holdings could develop if a country left the euro or if its economy weakened significantly and caused its budget deficit to soar. The risk of potential losses would make investors far less enthusiastic in buying Greek or Italian bonds than German bunds, so the broad benefit of QE would be diluted as rates would be higher in the weaker countries.

The thorniness of these issues may not be resolved at the January 22 meeting, which could prove unsettling to equity markets inEurope and globally.  It could also lead to more volatility in the currency markets. As this is being written on December 23, the euro is coming down to an area of chart support near 120.00 that would normally invite the covering of short positions. A delay in launching QE could ignite a really strong short-covering rally.  We believe that the long-term and larger problems facing the eurozone economy are structural and beyond the reach of monetary policy. This suggests the ECB has no other option than to further devalue the euro to boost inflation and hopefully lift growth through more exports.  As we wrote in the May 2014 MSR when the euro was at 138.00, "Shorting the euro has the potential to result in a profitable trade over the next year." It has so far and will likely continue to in 2015 since we think the euro could fall to 100.00 over the next 12-15 months.

Treasury Bonds

The 10-year U.S. Treasury yield has held within the downward sloping channel since September 2013. The only excursions outside of this channel occurred in December 2013 and September 2014,which proved to be highs, and in October and December 2014,which were lows. Each break above and below the channel proved temporary, which indicates that this channel is important and any breakout that is not quickly followed by move back into the channel is probably significant. As discussed earlier, 10-year government bond yields in a number of European countries are below the yield on the 10-year U.S. Treasury bond, which acts as an anchor for the 10-year U.S. Treasury bond due to its comparable value. This is one reason why yields in the Treasury market haven't increased more despite stronger growth in the U.S. and the looming prospect of a rate increase by the Fed.

If the ECB fails to deliver QE at their January 22 meeting, European yields are likely to spurt higher, which would likely lead to higher rates in the U.S. In November, the U.S. 10-year Treasury yield traded between 2.30% and 2.38% for 19 days, so any close above 2.40% would represent an upside chart breakout and also push the yield outside of the channel. An increase to 2.60% and then 2.65% could follow quickly. This is an important level sincethe 61.8% Fibonacci retracement of the decline in the 10-year yield from 3.04% to 1.87% is 2.59%.  We think this 2.59%-2.65% rangewill likely be a lid on any increase since the Fed is going to be morepatient in raising rates than investors realize.   GDP is likely to slowfrom the 5.0% rate in the third quarter of 2014 to less than 3.0% inthe first quarter of 2015 as dollar strength begins to slow exportsand wages fail to accelerate much in the first half of 2015.


There are several fundamental issues that could cause the stockmarket some trouble in the first half of 2015.  As we have discussed,volatility in the foreign currency market could become disruptive if the yen or euro begin to cascade lower, one of the emerging market currencies falls precipitously or the ECB fails to deliver QEas fast as the market is expecting. If oil prices remain below $60 a barrel, and especially if they fall below $40 a barrel, markets may react negatively to the consequences, including the prospect of slower global growth, the impact on U.S growth from less oil and gas development, the potential of defaults on energy-related bondsand geopolitical risks from countries whose fiscal budgets areadversely affected.

As we noted in last month's MSR, the overall technical health of the market has improved since the October 2014 low, but is inthe category of better, not great. We said the upside momentum from the October low had bought the market some time and that the calendar was potentially the biggest plus since the pressure on underperforming money managers to be fully invested would increase with each passing day.  We also said that as long as theS&P 500 did not close below 1,960, the market would probably press on until year-end.  As it turned out, the low on December 16 was 1,972.74.

The consensus rationale for the quick and dramatic turn around from the December 16 low was attributed to the Fed saying in the December 17 Federal Open Market Committee (FOMC) statement that it would be patient in raising interest rates. Anyone who may have thought the Fed was not going to be patient must have fallen asleep when Paul Volcker was the Fed chairman and then woke up on December 17.   Instead, we think the expiration of futures and options on December 19 played an outsized role in the big rally.  With just three days until expiration and the S&P 500 below1,975, traders had to be tempted to sell S&P 500 calls short at strike prices above the market (i.e., 2,000, 2,010, 2,020 and 2,030) after premiums were lifted by a jump in volatility from 12 to 25 in the six trading days prior, as measured by the Chicago Board Options Exchange Volatility Index (VIX). As the S&P 500 climbed above those strike prices, traders were forced to scramble to cover their shorts, which provided rocket fuel for the rally.

As this is being written on December 24, 2014, not a lot has changed from last month's assessment. The number of stocksmaking a new 52-week high has expanded but isn't at the levels seen in early July. The New York Stock Exchange (NYSE) advance decline(A/D) line marginally made a new high on November 26 compared to the August 29 peak, but then marginally failed to do so when the S&P 500 made a new high on December 23. The Nasdaq A/D line has continued to make lower highs since peaking back inearly March.  If the Russell 2000 Index fails to decisively break out above the double-top highs near 1,213 and then reverses, it would be a negative for small cap stocks. When the Major Trend Indicator peaked in early December, it bettered the early September high, but not the July peak. This continues the pattern of lower highs going back to last January, which shows that the market is gradually losing upside momentum.

These are all warning signs, but as long as the S&P 500 holds above 1,972, the uptrend is still intact. A close below 1,972, however, could open the door to a quick decline near the October low. We continue to believe that the S&P 500 will likely trade below the mid-October low during the first half of 2015.

Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

An advance-decline line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

A bund is a German federal government bond issued with maturities of up to 30 years.

Cash flow is a revenue or expense stream that changes a cash account over a given period.

The Dodd-Frank Legislation (named after Senator Christopher J. Doddand U.S. Representative Barney Frank) increases government oversight of trading in complex financial instruments such as derivatives and restricts the types of proprietary trading activities that financial institutions will be allowed to practice.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus thevalue of imports.  The GDP of a country is one of the ways of measuring the size of its economy.

The Major Trend Indicator is a proprietary technical tool that measures the strength or weakness of the market and helps identify bull and bear phases.During bull markets it helps indicate when the market may be vulnerable to a correction, and during bear markets it helps identify a potential rally.

The Nasdaq is a capitalization-weighted index designed to measure the performance of all NASDAQ stocks in the industrial sector.

NFIB Small Business Optimism Index is compiled from a survey that is conducted each month by the National Federation of Independent Business of its members. Measuring the health of small businesses can reveal potential trends in the stock market.

Price-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share.

A higher P/E ratio means that investors are paying more for each unit of income.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Russell 3000 Index represents approximately 98% of the investable U.S. equity market.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Thomson Reuters/University of Michigan Consumer Sentiment Index is aconsumer confidence index published monthly and based on answers from 500 telephone interviews of persons living in the continental United States.

VIX (the ticker symbol for the Chicago Board Options Exchange VolatilityIndex) is a popular measure of market risk and is constructed using the implied volatility of S&P 500 index options.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.

One cannot invest directly in an index.

  1. Agence France Presse, "Iran Says War Is The Only Thing That Can Stop Them Now," Business Insider, January 24, 2013.
  2. Andrew Ross Sorkin and Megan Thee-Brenan, "Many Feel the American Dream Is Out of Reach, Poll Shows," New York Times, December 10, 2014.
  3. Ibid.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise.  Past performance does not guarantee future results.  This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment.  Statistics, prices,estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

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