3 Things Worth Thinking About

by Lance Roberts of STA Wealth Management,

Deflation

The recent market contraction should not be as much of a surprise as it has been.  First, the markets were long overdue for a correction after an extremely long and unbroken run. Secondly, as I have addressed several times previously, the collapse in global inflationary pressures, along with economic growth, was an issue that would rapidly “wash up” on domestic shores.  To wit:

“I would most likely bet on the latter as the deflationary pressures that are rising in Japan and the Eurozone flow back into the domestic economy over the next couple of quarters.”

The chart below, which shows oil prices, interest rates and the 10-year breakeven inflation rate, are all stating that those deflationary pressures have come home to roost.

Oil-InterestRates-Inflation-101614

The collapse in oil prices is the effect of the drag in global demand combined with the recent surge in the U.S dollar.

Here is the “GOOD NEWS.” 

The collapse in oil prices, combined with a strong dollar, will provide consumers with roughly a $40 billion tax credit going into the winter. This should help provide some support to the domestic economy in the short-term provided there are no other offsetting factors such as a resurgence of the “polar vortex’s” that sapped economic growth last year.

Retail sales makeup about 40% of the personal consumption expenditures which comprises almost 70% of the quarterly GDP calculation.  Retail sales have slowed recently as the bulk of American’s is living paycheck-to-paycheck.  This is shown in the chart below of “control purchases” that reflects what households are buying.  (Note: Historically, control purchases below 4% annualized have been associated with very weak economic growth.)

Retail-Sales-ControlPurchases-101614

Therefore, there may be some pickup in retail sales in the months ahead which may provide a temporary buoy during the global economic storm.

Houston, We Have A Problem

I live in Houston, which as many already know, has enjoyed on of the biggest economic “booms” in history as oil production has had a major impact on the wealth and prosperity of the city.

However, as I have warned in the past, it is important to remember that all things are going in cycles and that the current expansion was unlikely to last forever.  The reason, I said this then, and still believe it now, is two-fold.

First, the development of the “shale oil” production over the last five years has caused oil inventories to surge at a time when demand for petroleum products in on the decline as shown below.

Oil-Consumption-Supply-101614

The obvious ramification of this is a “supply glut” which leads to a collapse in oil prices.  The collapse in prices leads to production “shut ins,” loss of revenue, employee reductions, and many other negative economic consequences for a city dependent on the production of oil.

Secondly, I have also discussed that the “fracking miracle” may not be all that it is believed to be due to fast production decline rates and massive amounts of leverage. Just recently Yves Smith posted an article discussing this very issue stating:

“The oil and gas sector is capital intensive. Drillers have borrowed phenomenal amounts of money, which was nearly free and grew on trees, to acquire leases and drill wells and install processing equipment and infrastructure. Even as debt was piling up, the terrific decline rates of fracked wells forced drillers to drill new wells just keep up with dropping production from old wells, and drill even more wells to show some kind of growth. One heck of a treadmill. Funded in part by junk debt.

 

Junk bond issuance has been soaring as the Fed repressed interest rates and caused yield-hungry investors to close their eyes and take on risks, any risks, just to get a teeny-weeny bit of extra yield. Demand for junk debt soared and pushed down yields further. And even within this rip-roaring market for junk bonds, according to Bloomberg, the proportion issued by oil and gas companies jumped from 9.7% at the end of 2007 to 15% now, an all-time record.”

While I am not suggesting that the Houston economy is set to collapse, I know many individuals that are heavily leveraged into the “energy” sector believing that things will “only continue to go up.” This is tremendously risky and anyone who lived in Houston during the 80’s will assure you they don’t.

Freaking Out

The long awaited correction has finally begun.  It should come as no surprise considering the markets have been in the longest near vertical run in the history of the market.  However, the question for investors is “what do I do now?”

The answer from the mainstream “bulls” is simply to do nothing.  After being caught heavily flatfooted with daily cheerleading of the markets, their only answer currently is to do nothing. After all “it’s not about timing the market but time ‘IN’ the market that matters.” Right?

Such a statement is a cop-out for the lack of an actual portfolio/risk management discipline of any sort.  However, as discussed earlier this week, the current correction was not only anticipated, but should also not be taken lightly.

A big concern at the moment is the conclusion of the Federal Reserve’s ongoing liquidity intervention program which has been the driver behind the markets unbridled advance since its inception in 2012.  The same thing occurred in 2011, which led to a topping process as QE2 was coming to an end.

SP500-2011-2014-101614

While no two periods are ever the same what is important is the current defense of 1850 level on the S&P 500 so far.  A rally from this level, which fails to attain a new high, suggests that the market will complete an important topping process in the months ahead.

The markets are currently on very important “sell signals,” but also “grossly oversold” on a short-term basis.  This setup suggests that investors should be patient and await a rally back to resistance to reduce equity risk in portfolios for the time being.

SP500-MarketUpdate-101614

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“The point is that there are many risks investors should not ignore. Making up losses is much harder than reinvesting stored capital once a clearer picture emerges. While the current belief that a correction of magnitude in the markets is "inconceivable," I am not sure that word means what they think it means.”

Caution is advised.

 

 

Copyright © STA Wealth Management

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