Do plunging oil prices signal a weak economy?
We have a big economic calendar. Some participants will be slow in recovering from their time off. Some may even stay up late for a football game on Sunday night. (Mrs. OldProf will be there until the finish, regardless of the score). There will be plenty of economic data, but it might not matter.
The world of punditry has decided that the market moves must mean something important. “The market is sending a message”, they say. Oil prices have taken center stage. With oil about to “break support” they will be asking:
Last Week Recap
In my last edition of WTWA I guessed that many would take the week off and there would be a lot of discussion about shopping. I was right about people taking time off. By today, CNBC was even recycling Wednesday interviews. Shopping got short shrift in the midst of some big market moves, mostly down.
I actually focused on the three key themes facing the market. It is just as relevant as it was last week. If you missed it, I urge you to take a look at the theme section and my final thought.
The Story in One Chart
I always start my personal review of the week by looking at a great chart. This week I am featuring Investing.com. Their futures chart shows overnight trading and references to key news. Check out the interactive version online.
The market lost 3.8% and the weekly trading range was only slightly higher at 4%. I summarize actual and implied volatility(NYSEARCA:VXX) each week in our Indicator Snapshot section below.
I noted in my last installment that I was going to be working this week but planned to take time off from writing. Everyone should seek a special family focus when possible. The market decline and the abundance of bad advice have convinced me that I should write this weekend. Rather than my normal update of news items and investment ideas, I am going to focus on a single important theme in addition to our regular indicators. I hope readers find this approach useful.
The calendar is important, offering something for everyone – housing, personal income, the Fed, and the 2nd read on the GDP.
Congress will be in the lame duck session and we’ll see plenty of speeches from all sides. Most watched will be one from Fed Chairman Powell Wednesday afternoon at the Economic Club of New York.
Briefing.com has a good U.S. economic calendar for the week. Here are the main U.S. releases.
Next Week’s Theme
The market decline has sparked a search for the underlying message. The correlation between oil and stock prices has been strong, so that commodity leads the questioning:
Do plunging oil prices signal an economic decline? Even a recession?
A highly respected (and highly paid) analyst for a big firm was asked his opinion on CNBC Friday morning. (I’ll omit the link, but you can find many similar comments). He briefly noted that the oil price decline had something to do with supply, but rapidly switched to economic weakness. “A $25 decline has to mean something!” The CNBC anchors agreed.
Starting with an opinion substitutes confirmation bias for critical thinking. Instead, let’s begin with an understanding of some facts.
Supply and Demand
As with everything else, oil prices reflect supply and demand. This is a basic concept that everyone pretends to understand, but few actually do.
This 2007 article is an excellent tutorial on economic analysis of oil prices. Robert Smithson (The Oil Drum) demonstrates the importance of looking at both the supply and demand curves for oil (NYSEARCA:USO). He begins by explaining that in the short term both supply and demand are relatively inelastic. This means that a small change can lead to a large price movement. Here is a shift in supply illustrating the effect of the OPEC oil boycott. The reduced supply – at any price point – shifted the supply curve to the left, increasing prices.
In this chart he shows the impact of a demand increase (at any price) using the example of trends in emerging markets(NYSEARCA:EEM). As demand increases, the curve shifts to the right increasing prices.
Smithson notes that the story is different in the long run. After considering years of price movement, he notes:
“The lesson here is simple: there is no “over” or “under” supply, there is only the price at which the market clears. And over the long-term, high oil prices will tend to encourage consumers to either reduce energy(NYSEARCA:XLE) consumption or shift to other forms of energy. Similarly, investment in either inhospitable areas or in developing technologies will result in greater quantities of oil or synthetic crude coming on to the market. Each boom in the oil price sows the seeds of its own destruction”.
Applying this basic analysis to the current oil price environment explains why the sudden shifts in the supply curve had such a dramatic price effect.
The prescient commentary on long-term elasticity is also helpful. Consider just one element of the supply curve – the cost of drilling a new well. The Dallas Fed Energy Survey (via the FT) reports these breakeven prices for shale.
The shape and placement of demand and supply curves is difficult to determine from current data. For this reason, most sources simply describe the current levels of each. The current level of supply is higher than the 5-yr average, and rising. (EIA – This Week in Petroleum).
For a time, markets believed that supply would be more limited. Reinstating sanctions against Iran initially pushed oil prices higher. OPEC was expected to cut supply as well.
Instead, the US granted exemptions to several consumers of Iranian oil. The Saudi’s, encouraged by the US, are pumping more. The President talked of releasing oil from the Strategic Petroleum Reserve. Investing.com notes:
Thanksgiving holiday volume provided the perfect market condition for oil bears to lure in longs and hammer prices down 8% after the dead-cat bounce of 2% Wednesday. Oil bears also came precariously close on Friday to their long-time target: breaking the $50 support for West Texas Intermediate. They could achieve that as early as next week, barring a flip in sentiment. The $60 support for Brent, meanwhile, was shattered.
World oil demand continues a rising trend with some quarterly variation. (IEA)
Statista has a longer history with some 2019 projections.
Oil Prices and Recessions
High oil prices are frequently associated with recessions. Prof. James Hamilton, another of our regular sources, is a leading expert on this subject. He concluded that the 2007-08 period might not have been characterized as a recession without the effect of oil prices – “strong demand confronting stagnating world production.”
When a January 2016 opinion piece in the WSJ suggested the possibility of a recession caused by low oil prices, Prof. Hamilton gently but firmly refuted this idea. The key effects were a redistribution from producers (and those who supply and finance them) to consumers.
There are several important and compelling conclusions.
- Falling oil prices are not a reliable economic signal. Those asserting the opposite are attributing all price movement to demand, ignoring the supply story.
- Worldwide demand remains strong.
- The apparent correlation between oil prices and the stock market is not a causal relationship – in either direction!
The Trump Administration, warns the FT, should beware of trying to push oil prices below $50/barrel. Low oil prices are also sending an errant signal to markets. Low is good for consumers, but perhaps not too low.
Those interested in energy stocks might view the $50 oil price as providing fundamental support. It could be a wild ride, however.
The lesson for most investors is an old one: Ignore the daily chatter on this subject. Most of the instant oil experts do not know contango from a crack spread.
More broadly, the oil price blunder is only one of many. Searching for a message from markets is silly when the traders are wrongheaded. The mistaken oil inference is affecting the value of every stock that is sensitive to economic growth.
A more helpful and profitable viewpoint comes from Vitaliy Katsenelson:
How do you deal with market declines? Stop looking at the market as if it were a casino and start treating stocks as businesses that you are trying to buy at a discount to fair value. Stock price is an opinion of what the market is willing to pay for this business right now. Yes, it’s an opinion, not a final judgement. The stock market is going to be a miserable place for you in the long run if you take market opinions on any given day seriously and treat them as final judgements.
If you start treating stocks as businesses and you start analyzing them and valuing them as such, then market drops stop being a source of pain and turn into a source of pleasure. I read somewhere that most money is made during bear markets (when you buy stocks on the cheap) – it just doesn’t feel that way at the time. Even if you are fully invested (we are not) why does it really matter that the market decided to price your stocks lower today (unless you believe the market is right)? Will it matter three, five years from now? If you own undervalued companies, they may get more undervalued before they become fully valued. As long as you’ve got the valuation right, you’ll eventually be proven right.
We follow some regular featured sources and the best other quant news from the week.
I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.
The Indicator Snapshot
Short-term trading conditions remain at high alert. The identification as “very bearish” is a reaction to volatility, not a prediciton of market movement. There is always a risk/reward balance to consider in your trading. When conditions are technically challenged, we watch trading positions even more closely. Each of our models has a specific exit strategy. The technical health rating may drop enough for a complete trading exit. It got close to that level recently.
Long-term trading has worsened a notch on a technical basis. Regular source Georg Vrba warns that a “death cross,” the 50-day MA crossing the 200-day MA is almost inevitable. This helps to explain the reactions of technically-based investors. The death cross sounds bad, but has mixed results as a leading indicator. Georg explains more fully.
Fundamental analysis remains strongly bullish. Earnings are great, prices are lower, and there is even less competition from bonds. We reduce fundamental positions (as we did in 2011) when we get a warning from the recession or financial stress indicators, not merely as a reaction to technical signals.