“There are decades where nothing happens; and there are weeks when decades happen” – Vladimir Lenin[i]

Sometimes historical events gradually evolve and develop – progress almost seems imperceptible.  Other times they happen very quickly and are impossible to ignore because they often have far reaching consequences.  For the past several years of the financial market recovery, we’ve experienced the former.  However lately we’ve gotten some “weeks when decades happen”.

 

These recent “decades” take the form of an over 50% plunge in crude oil within a few months, the stock market’s October drop and then extraordinarily quick rebound to new record levels, a bond market “flash crash”, and European bond yields that are negative (that’s right – depositors/lenders are paying the borrower to take their money). To be sure, these incredible developments are within the context of a pretty amazing backdrop of central banks championing more inflation (with no opposition from their citizens) and irresponsible fiscal policies.

 

Few 2014 stories rival the collapse of crude oil.  After peaking over $100 per barrel in July, prices slid throughout the rest of the year with the collapse accelerating during December.  This final dive was sparked by Saudi Arabia’s Thanksgiving Day announcement of their production would not be cut.  For many years the Saudis would increase or cut production to stabilize prices within a range so this decision indicated a new direction.

 

However, oil’s decline is about much more than OPEC’s production or falling demand.  While crude inventories have risen, they have not spiked to a point that would result in the price collapse that we have experienced.  For example, U.S. crude inventory totaled 1.752 million barrels at the beginning of January 2014.  They increased 5% to the 1.84 million barrels at the beginning of January 2015.[ii]

 

Rather than just pure supply and demand, there is a belief that crude’s implosion is a function of the end of quantitative easing (QE).  Capital expenditures in the oil and gas industry have been running above long term averages for the past few years driven, in part, by easy money.  The oil and gas fixed investment as a percentage of total U.S. private investment ranged between 1.5 and 3% for the 20 years from the mid 1980’s to the mid 2000’s.  From 2005 to 2014 this increased from 4% to approximately 7.5% of total capital expenditures, well above the trend and unsustainable for the long term.[iii]  As crude prices started to decline, the realization of this potential overcapacity accelerated the move lower.

 

Another related development that contributed to oil’s drop was artificial demand through the crude oil futures market.  Like the capital expenditures story, this has its roots winding back to QE and ZIRP (zero interest rate policy). In a world of increasing dollars looking for a return, the crude oil futures market presented a yield alternative.  As oil was near $100 a barrel and, more importantly, the term structure offered “positive carry” (longer dated contracts were bought at discounts to the spot price), traders were paid to hold the contract as its value increased with the passage of time.

 

Wall Street is infamous for taking a good idea and then pushing it as far as it will stretch so when this started to work everyone piled on.  The result was a lot of long crude oil futures contracts.  Josh Ayers, Paradarch Advisors, LLC, estimates that the futures market added net $56 billion of added demand at the June 2014 peak.  Furthermore, Ayers estimates that the rate of growth was highest from the beginning of 2013 to June 2014 and during that time speculators increased the paper demand for oil to over 400,000 barrels per day.[iv]

 

Clearly the unwinding of this condition was a contributor to crude’s drop.  Where crude ultimately makes a bottom is subject to much debate.  However, the net positions held by speculators, still much higher than historical levels, suggest crude could move lower before bottoming.

Heads They Win, Tails We Lose

 

Another more complicated event is the negative interest rates spreading throughout the markets.  To be sure, it is hard to fully understand the mechanics of negative yields and what this means but it’s essentially allowing banks to charge interest for depositing money in your account.  Or in the case of the bond market, fixed income buyers getting back less than the principal at maturity.

 

This bizarre financial state is another extension of central bank policy.  As the Fed, ECB and their counterparts keep short term rates at zero, the longer dated rates also move lower.  For example the French 10-year debt was priced to yield 0.60% while the German 10-year bond’s yield closed last week at 0.28%.  Remarkably, Germany’s 2 and 5 year bonds were priced to yield negative 0.22% and 0.14% respectively and the Swiss 10-year yield is negative 0.30%. These levels are more astonishing when compared to the U.S.’s 2% on the 10-year note.[i]

 

A reasonable question is why anyone would consider buying these bonds.  The reality is that a bond mutual fund or some other institution might be forced because that’s the only market sector they can invest in.  Also, investors seeking safety during tumultuous times, like those facing Europe, turn to the shelter of government debt regardless the terms.  This bizarre situation will someday end but let’s hope it’s a result of a return of normal markets rather than loss of confidence together with another crisis.

 

Switching from Old World debt markets to the New World stock markets, it seems like decades are happening daily on the U.S. exchanges.  As we referenced above, we had a quick 8% pullback in October which appeared to be the start of something larger.  But prices swiftly reversed and not only were losses recovered but stocks went to reach new all-time highs in December.

 

After climbing back to this record level, stocks traded in an approximate 5% range for the next seven weeks and actually finished January with losses.  This reversed in February as the major indexes broke out of this range mid-month and have rallied to new records.  Here are the averages for February and year-to-date.

 

                                         February 2015     2015YTD[i]
Dow Jones Industrial Average  +5.6%            +1.7%
S&P 500                                 +5.5%            +2.2%
Nasdaq Composite                  +7.1%            +4.8%
Russell 2000                           +5.8%            +2.4%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

 

It’s likely a futile wish for a return to “decades when nothing happens”.  And looking at the current financial market landscape, it’s pretty easy to predict continued rapid change.  Some obvious items include:

  • The Fed will likely start raising interest rates later this year.
  • Greece may exit the European Union.
  • U.S. stocks are no longer undervalued.
  • 2015 earnings estimates are being reduced (energy companies are part of this).
  • Geopolitical tensions.

Of course, these might just be bricks in a “wall of worry” that stocks often climb.  From that perspective, there is plenty of ammunition.  But considering that we will reach the 7th anniversary of the stock market’s financial crisis low later this month, maybe we are entering a period where risk is priced higher.  It’s a potential headwind should it occur.  However, economic growth seems likely to continue and with it corporate earnings.  This higher trajectory for the bottom line should ultimately help equities.  Whatever develops, we expect “decades happening in weeks”.

  

Jeffrey J. Kerr, CFA


[i] The Wall Street Journal, February 28, 2015

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional

 

 

[1] Lenin – Selected Works, 1975

[1] www.eia.gov/dnav/pet/hist

[1] Gavekal, Dragonomics, January 6, 2015

[1]Paradarch Advisors, February 15, 2015

[1] The Wall Street Journal, February 28, 2015

[1] The Wall Street Journal, February 28, 2015

 

 

 


[i] The Wall Street Journal, February 28, 2015


[i] Lenin – Selected Works, 1975

[ii] www.eia.gov/dnav/pet/hist

[iii] Gavekal, Dragonomics, January 6, 2015

[iv]Paradarch Advisors, February 15, 2015

 

 

 

 

 

 

 

 

 

 

 


 

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.

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