“There comes a time in every man’s life when man looks in the abyss, there’s nothing staring back at him. At that moment, man finds his character” is a great line from the 1987 movie Wall Street which captures what investors dealt with this past week. Except in this case, on Wednesday, when stocks were being obliterated and the S&P 500 flirted with its critical 1800 support level, investors looked into the abyss and found not just character but also buyers. Stocks then mounted an impressive intraday rally and managed to close well off the lows. Thursday and Friday saw nice rallies which capped off an extraordinarily wild week. The S&P 500 finished the week over the psychologically important 1900 level on the back of oil staging a ripping 9% rally on Friday alone. So this now begs the question, did we find the bottom? I think so. We finally had a moment of true fear that was met with significant buying interest which is typical of a market bottom. Now, people are trying to compare this recent decline to 2008, but the financial backdrop is completely different. I wouldn’t expect to have the same type of vicious sell-off given we are nowhere near that type of crisis level. That said, let’s take a look at what went on this week, and what it means for investors.
Oil once again stole the show this week as WTI traded in a 17% range on high volume. As we saw on Wednesday, oil was leading stocks on the way down and then brought them back up. Is this correct behavior? No, but it is the reality of the situation right now. Until oil stabilizes, stocks will be held hostage to its movements. Fortunately, we can mitigate our psychological torture from this captivity by analyzing some of the potential negative outcomes of an oil crash. While it’s impossible to know all the resulting consequences from the oil crash, we can nail down a couple large ones. General consensus is that the most danger for the U.S. economy lies in two places:
- Bank loans made to the energy sector.
- Corporate debt issuance from the energy sector.
In terms of loans, the big banks have actually done a great job at managing this exposure by not having even a remotely significant percentage of assets in the energy sector. As this CNBC.com / GS research highlights, the big banks have an average of just 2.4% of total loans outstanding to the energy sector. This is a very low level and should allay any thoughts of risk for this area. As for corporate debt, there is trouble as the bonds of the weakest issuers have been trading at distressed levels. The fact is that there will be some bankruptcies. How many will there be is still unknown. What we do know is that there are people actively researching these opportunities and waiting to take advantage. This is a natural series of events in an industry that has been disrupted by technology (fracking). The oil industry has been literally turned upside-down from a major consumer like the U.S. turning into a major producer. The bottom line is that weak companies being restructured is the only way to move forward on solid ground. I think the best way to treat the oil situation is from a common sense perspective that low energy helps far many more people than it hurts. The roughly $210 billion (based on EIA and AAA Fuel Gauge data) that consumers have saved since 2014 is a massive tailwind for consumption and business. To put that $210 billion in perspective, the entire 2008 financial crisis stimulus package from the government, which was paid for by our tax dollars, was $170 billion. The tax-free money saved by the drop in energy prices along with increased regular wages from a full employment labor force is also showing up in retail sales data.
The above chart shows a healthy level of consumption.
Along with the rollercoaster ride in oil and equities on Wednesday, we also got the December CPI reading on inflation. The “core” reading which strips out food and energy moved up .1% for the month and is now up 2.1% for the year. Like most economic data series, the devil really is in the details. Looking into the CPI data, we can see the divergence between the services and goods producing sectors of the economy. The table below shows where inflation and deflation lie in the two sectors. In terms of total advances versus declines, 93% of services items have increased year over year while just 50% of goods items are up. This shows the pervasiveness of the commodity decline in goods prices and the true strength in services. What we also see in the data is that there is an indisputable increase in the cost of living. Something that I’m sure the Fed is taking note of.
This week, we also got two significant reports on the housing market: existing home sales (EHS) and housing starts. EHS, which represent 90% of total home sales, jumped 14.7% from November and is now up a healthy 7.7% for the year. Part of December’s jump is due to the implementation of new sales closings procedures which delayed some sales from November into December. Even with the new rules, sales activity is still at a historically strong level as can be seen in the chart below. However, a critical distinction needs to be made when looking at EHS data pre- and post-crisis. That distinction is that pre-crisis lending standards were incredibly loose and allowed many sales to happen that would not have happened with today’s standards. This is why the strict nature of today’s lending standards has created a much higher quality and sustainable housing market. Today, we have both quantity and quality of transactions.
The housing starts data also came in slightly down from November but still well up for the year. The building permits component was up 14.4% for the year while starts were up 6.4%. We really need to see the starts data pickup if there is ever going to be any price relief for first-time buyers. As millennials start forming households, the housing market is getting tighter by the month. EHS data frequently cites the lack of inventory as driving prices higher and reducing transactions. All in all, the housing market is in good shape, and I expect it to continue to be a significant contributor to a sustained economic expansion.
A point of caution which did come up this week was in the weekly unemployment claims data. While still at historically low levels, the data has been coming in on the weak side for the last 3 weeks. Some of this is definitely seasonal as the Department of Labor points out, but it is never the less a concern and needs to be addressed. The bottom line is that employment is the key to everything. There will be no consumption without income. Right now, the labor market is still strong, but if weekly claims continue to drift higher, that will be a concern.
Now we head into a week that has major earnings reports coming from Apple, Amazon, MasterCard and Visa to name just a few. So we’ll finally get a handle on exactly what the consumer has been up to this holiday season. I’ll be especially interested to see the growth in processed transactions from the credit card companies which I suspect will be up significantly. We also have a full slate of economic news coming that includes durable goods orders, new home sales and fourth quarter GDP. We could get a decent print out of durables given the surprise uptick we got in the Markit manufacturing report on Friday. Manufacturing has been all but dead as of late and any uptick will be an added bonus. As I have stated before, the U.S. economy is driven by services and consumption, but any help from the manufacturing sector is more than welcome. So the moral of the story here is that we’re headed for more volatility and will probably have more moments of looking into the abyss. But remember, every time that happens, stay focused on the data and use the opportunity not only just to build character, but also to build a strong portfolio.