Fear Lower Oil (prices)

My Comments: Frankly, I enjoy paying less to fill up the car with gas. There is more cash left in my wallet for me to deal with other things I need to buy. At the macroeconomic level, it will help retailers have a stronger holiday shopping season. That will help the economy. But like most things in life, what gets added with one hand results in something being taken from the other.

The following comments are by someone who speaks a language that few of us understand. I’ve highlighted one sentence in para 4 that I think is a takeaway from this. While you may like the idea of shale producers going bankrupt, it’s not a good sign for down the road.

Additionally, the comments in the last paragraph help me better understand why it’s been so hard for investment clients to participate in the historic climb of the DOW and the S&P500 these past two years. The Fed’s activities have overridden the usual strategies to participate without being over exposed to risk. That risk is now more meaningful than ever.

By Michael A. Gayed, CFA  /  Nov. 17, 2014

Summary
• The Utilities sector, perhaps the most predictive sector of the stock market, broke down meaningfully.
• The faster Utilities underperform, the more likely on a short-term rolling basis in the coming weeks they are to outperform.
• Wall Street seems to be under the impression the year is over, forgetting that the last time QE1 and QE2 ended, stocks corrected severely a month later.

The S&P 500 (NYSEARCA:SPY) stocks held on to moderate gains as the average stock was flat to down in a week that on the surface looked uneventful, but from a sector standpoint had important movements take place. The Utilities sector (NYSEARCA:XLU), perhaps the most predictive sector of the stock market, broke down meaningfully relative to the broader stock market starting Wednesday. At first glance, one might think after reading the 2014 Dow Award paper on Utilities (click here) that this is inherently bullish for stocks given that when the Utilities sector underperforms, historically going back to 1926 stock market volatility drops and equities rally.

And while this is true, the issue is the speed of underperformance. The faster Utilities underperform, the more likely on a short-term rolling basis in the coming weeks they are to outperform as that lower relative level dictates the soon to come change in rate of change. This means that while Utilities breaking down is bullish, the speed may actually be a set up for another pulse of risk-off strength, potentially at the tail end of November for another trigger to get defensive through either an all-in rotation to defensive sectors away from cyclicals (as our equity beta rotation strategy does), or an all-in rotation out of equities into Treasuries (as our inflation rotation strategy does).

We are only a few short weeks after the end of Quantitative Easing, and Wall Street seems to be under the impression the year is over, forgetting that the last time QE1 and QE2 ended, stocks corrected severely a month later. That would imply December may actually be a high risk month. Ten-year Treasuries (NYSEARCA:IEF), which have held in a tight range just above 2.3% are still signaling concern about US growth and inflation, as yields still seem to ignore what tends to be negative seasonality for Treasuries that begins in November. Combined with Junk debt taking another relative hit, the precursors to a meaningful breakdown seem to be taking place potentially as credit spreads widen and fail to confirm overall bullish sentiment into year-end.

In Arkansas last week, I did a presentation on our award winning papers, and someone in the audience was joking sarcastically with a prior speaker that lower Oil is deflationary, making fun of the idea that saving money is bearish. When I got up, before beginning, I addressed his point quickly and said “be careful what you wish for” when it comes to lower Oil. The meme out there is that lower Oil is bullish, but that completely disregards the speed with which Oil breaks down. Historically, meaningful declines in equities have been preceded by Oil breakdowns.

Furthermore, the faster Oil (NYSEARCA:USO) breaks, the more likely highly leveraged shale producers go bust. Popular junk debt ETFs (NYSEARCA:JNK) and indicies have Oil and Gas as the heaviest sector overweight within those averages. Collapsing Oil could set off a deflationary butterfly effect whereby spreads widen and filter through to all corporates, which in turn would be a form of credit tightening forced by the market as opposed to the Fed.

For us, we believe the post QE3 environment is extremely positive for the types of aggressively defensive rotations both of our main strategies (one alternative, one equity) favor. Both are based on proven historical indicators of coming regime changes in stock market volatility. The challenge since QE3 began has been that the Fed steamrolled any kind of a “risk trigger,” causing any warning signs of volatility changes to be ignored by markets. With that distorting factor out of the way, it stands to reason volatility and correlations revert to historical cause and effect.

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