“It is better to be vaguely right than precisely wrong.” – Wildon Carr, 1942
My last market commentary’s title was “Dollar Is Up, Oil Is Down, Stocks Get Confused”. If you’re wondering why I haven’t written a newsletter for the last few months, that’s because this analysis has been as valid as it was a few months ago. Since November 2014, stocks have been in a sideway trend, dollar has been climbing up and oil looking for a bottom at around $40-$50 per barrel.
Some investment strategists argue that at this stage of the bull market, the name of the game is picking individual investments instead of indexing. They put this forward by looking at breaking correlations among asset classes and securities. In the early stages of a bull or a bear market, correlations rise, related asset classes move in tandem. As the trend starts to mature, correlations break and stock/bond pickers become popular again.
Though there is some truth in this, correlations haven’t shown a sustainable divergence pattern, meaning, just when they seem to be on their own, a heavy hitter gets a seat at the table and a brand new set of cards are dealt. The US dollar, oil, cold weather, port disruptions, Janet Yellen and foreign tensions are the most noteworthy examples.
I’ll argue, macro factors such as mentioned above are still the dominant players and paying attention to them would be wise. British Philosopher Wildon Carr’s quote makes so much sense when applied to capital markets. A diversified portfolio by definition will have less than perfectly correlated securities and some of them will zig while others zag. If you call this being vaguely right, it surely beats being precisely wrong on a stock holding that is 100% of your portfolio. So please remember this before you get too comfortable with your individual stock selections and don’t dismiss your diversified portfolios entirely, but rather supplement your allocation with individual holdings to get the best of both worlds.
Oil has been, and probably will for a while be, a headline topic for market followers. It has lately settled in $40-$50 per barrel range with significant daily price fluctuations. I have recently seen a report on future oil contracts, an estimate of the future price traders are willing to pay, and it points to $30/barrel oil. I personally think $40 dollar is the near term floor simply because below those levels, there aren’t many producers that can survive without making money.
This is a double edge sword. Cheaper oil pushes prices down and as a result helps improve savings rate along with consumer confidence. On the other hand, troubled refineries and depressed levels of oil production put a cap on capital spending. This has already been seen in shrinking durable goods orders, which is a big red flag for the markets. In the long run however, once the savings come back to the system as investments or pent up demand, the lost production can be re-gained. So in the short term, lower oil prices may hurt production and capital spending, but increased savings can translate into investments and higher consumption in the coming months.
Can you have too much of a good thing? Too strong of a dollar can surely be an example. The timing of the dollar strength has taken care of two interrelated worries for some: An overheating economy and inflation. If you remember, the 3rd quarter growth rate was 5%, which is high enough to cause inflation and push FED to move with their rate hike sooner rather than later. A stronger dollar lowered import costs and subdued inflation, while making exports more expensive and lowering large exporters’ profits. 4th quarter economic growth rate was 2.2%, clearly nowhere near overheating territory, accompanied by a 1.8% inflation rate. The strong dollar is not solely responsible, but surely had a role in it. In the short term, we may observe a reversal of this trend as there has been an excessive momentum behind the dollar. In the long term however, especially against the currencies where the central banks are implementing their own version of monetary easing, it is hard to see how the dollar can lose significant ground. If you’ve read about the Euro/Dollar parity, this projection refers to Euro and the US Dollar being equally valued, which would require the Euro to lose about 7%. That’s Goldman Sachs’ projections by the year end.
Six years since the beginning of the recovery and the bull market, the biggest gorilla in the room has been the FED. There are two unstoppable forces I’d never knowingly (can’t say I haven’t made mistakes) stay in front of: the market trend, and the FED. I take pride in writing my commentary as an easy read in everyday language, but if the FED is the most important player and the timing of the rate increase is extremely important, then let’s make an exception and dive deeper into the statements of their last meeting.
In the US, the FED has two mandates, to keep the inflation at or around 2% and sustain full employment, which is 5.5% unemployment rate. So, since the current inflation rate is at 1.8% and the unemployment rate is at 5.5%, are we right at the doorsteps of a rate increase? No, not for another 6 months or so it seems, and here is why: NAIRU.
Not to be confused by Nibiru, the Babylonian god Marduk’s home planet, NAIRU stands for non-accelerating inflation rate of unemployment, meaning the unemployment rate below which inflation rises. In other words, once the unemployment rate goes below NAIRU, the FED would see this as an inflation warning and start sharpening their pencils to increase interest rates to fight inflation.
This unemployment rate, the rate below inflation rises, has historically been 5.2%-5.5%. The most recent FED statement lowered it to 5.1%. This is significant because it simply means the FED will not use unemployment as an excuse to raise rates until it reaches to 5.1%, not the previous estimate of 5.5%.
Also, if you add the part time employed to the unemployed number (U6), it is 11%, and all the more reason for the FED to delay the rate hike from June to September.
Extreme Weather Conditions and Port Disruptions
While here in California we are dealing with a drought in historic proportions, the East Coast and Mid-West has gotten hit hard with extreme cold weather conditions this year and especially the latter has significant short term effects on the economy. When it is freezing cold, people shop less, certainly delay purchasing big ticket items such as cars, home appliances and real estate. To add insult to injury, strikes in major ports, especially on the West Coast, has slowed down or stopped all together the shipment of goods.
In aggregate, the US economy has slowed down more than anticipated and the markets have noticed. Like any other short term headwinds, these conditions have for the most part passed (except the drought) and the pent up demand will likely start adding to the economy in the coming months.
All these macro factors are affecting your investments in one way or another. With some exceptions, no individual holding is immune to macro regimes. A strong dollar lowers large US companies’ overseas profits, cheap oil makes it more difficult to profit from energy related industries, these two trends tie in to interest rate and inflation expectations, and Janet Yellen’s statements are carefully watched by the markets.
The bottom line is that the uptrend in US stocks is still intact. So use the dips as buying opportunities, have a globally diversified portfolio, look for companies with wider access to domestic markets and rebalance periodically.
Hope you’ve enjoyed my market update. For questions or comments, please feel free to reach me at email@example.com
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