A Volatile Start to 2016: What’s Driving the Markets These Days

January 21, 2016 8:06 pm
Derek

Derek M. Amey

Managing Director & Portfolio Manager

There’s an old axiom that when looking to buy a house, the only three things that matter are “Location, Location, Location.” Well as 2016 has started, the market has really begun to worry about “Oil, Oil, Oil.” Yes there are other issues, many of which you are all quite familiar with, but at this point oil is driving the bus. Yesterday perfectly exemplified this, as we had no news from China, no Fed news, a fairly light economic calendar, but oil started out very weak in early trading and led everything lower. This is an interesting phenomenon, whereby LOWER energy prices are now the concern.

Since the early 1970’s, every recession in the United States has been accompanied by a spike in oil prices. This should seem fairly logical, as the price of oil (and energy for that matter) tend to be a significant input expense. As such, the correlation between the direction of stocks and the direction of oil prices historically move inversely with each other. As oil prices drop, typically equity markets rally. In fact, according to one expert (Cumberland Advisors), the price movements of stocks and oil over the past 5 years have seen a correlation of -72%. As oil has dropped, stocks have rallied. That relationship has changed over the last month and a half. According to Cumberland Advisors, the correlation between the price of oil and the S&P 500 has risen to +92%!

Why has this dynamic changed?
One common dynamic of markets under extreme duress is that typically, uncorrelated assets all start to trade in sync with each other, except for cash and more recently Treasuries, which benefit from a “flight to safety” aspect. As much as experts and academia types want to believe that markets are efficient, the reality is that fundamentals fail to matter in a “bunker” type market. The day-to-day movements of stocks, bonds or any investments are typically not driven by the fundamental analysis, but rather investor sentiment. It’s not logical that the real world oscillates back and forth from “not so great” to “pretty good”, but stocks frequently move from “doomsday” to “everything is perfect.” Currently markets are in a panic mode, where every concern, from the realistic to the improbable, suddenly takes on a life of its own.

Recession or not?
Paul Samuelson, the late economist and Nobel Prize winner once said back in 1966:

Commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions!”

Since the end of WWII every prolonged bear market (-20% in equities) has been met with a recession here in the United States. This is why Wall Street is obsessed with trying to guess when the next recession is coming. However, history has shown that just like any of us, Wall Street is notoriously bad at accurately predicting recessions. Far too many analysts will fall prey to confirmation bias. Whereby like beachcombers turning over every rock in search of treasure, they will keep searching data points until they find something that confirms their fear.

The current economic realities here in the US are not flashing to any imminent recession. 2015 saw the most autos sold in this country ever. Total employment in the US rose by 2.45 million, which marked three straight years with more than 2 million jobs gained. We haven’t seen that much consistent job growth since the late 1990’s.  Hotels were on pace for record occupancy for the full year. The housing market continues to heat up. While these facts are not a conclusive list of the strength of our economy, prior to a recession one would expect to see weakness in some or all of these indicators, which is notably absent at  the moment. Wall Street and Main Street can often diverge at times as investors begin to craft outcomes that currently do not exist, but if the reality fails to live up to the worst fears, one would expect them to meet again.

We are not Pollyannas about the economic headwinds that the globe and the US economies are facing. Betsey’s blog post from the other day speaks to many of the high level issues that the markets are trying to digest.  As such, we will continue to analyze the fundamental data and operate as we always have. Panic is not an investment strategy, and we will continue to approach the asset allocations for our models in a disciplined and diversified manner. We believe the economic underpinnings of the economy have not substantially changed during the course of the pullback. We continue to experience a muddle through recovery with more good news than bad news and little threat of a recession, credit crisis or bursting of a bubble.

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Derek Amey serves as Managing Director and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Derek’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.