Mind Your Footings: The Global Slope Is Getting Slippery

This will be a shorter than normal commentary as I’m on my annual pilgrimage to Hilton Head Island to see old friends, talk about markets, politics and other subjects not suitable for a family friendly publication and to torture ourselves on the golf courses. As an aside, you are an evil man Pete Dye.

I don’t generally write while I’m on these trips, preferring to use this time to think about things and pick the brains of some very smart people while I’m here but because of last week’s volatility I felt like at least a short note was necessary. The first thing to recognize is that the volatility we’ve seen recently is normal. What we’ve seen over the last couple of years, an almost complete lack of volatility, is what is abnormal. The second thing to recognize is that the drop so far totals a rather pedestrian 5%, half what is considered a normal correction. So based purely on the price action so far, this means absolutely nothing.

Of course, there is often more to the story than just the headlines and the indices. The S&P 500 may be only down 5% but there are plenty of stocks within the index that are down considerably more, especially if they happen to reside in the commodity/materials sector. Small cap stocks are already in official correction territory with the Russell 2000 down about 13% from the peak. Foreign markets are also down considerably more with the EAFE down about the same as US small caps since the peak. France and Germany are both down roughly 20% from their peaks as the European economy continues to deteriorate (Germany reported some truly awful industrial output and export numbers recently). Oil stocks are almost in bear market territory, down about 17% from their peaks. There are also some bright spots with healthcare and utilities leading the way but that isn’t particularly comforting since those are areas people buy when they’re worried.

Last week’s volatility is a reflection of the growing uncertainty surrounding global economic growth and therefore corporate earnings. Europe has been getting most of the attention but there are worrying signs in other areas of the world as well. Ford and Nissan last week reported big drops in their Chinese business and the German export numbers also point to a more considerable slowdown there. Emerging markets will feel the pain of a slower China and stocks there, which had been a bright spot this year, are now in official correction territory, down over 10% from their peak.

The drop in oil prices is also getting a lot of attention and as I’ve warned recently, lower oil prices are not the boon they once were for the US economy. The stocks of oil and gas companies involved in fracking have been some of the hardest hit in the selloff. With prices in the low 80s a large number of these companies are simply not viable and the further prices fall the more companies will be affected. As for the impact on the overall economy, the concern should be the effect on capital spending where oil and gas companies have represented nearly a third of the total over the last few years. Obviously, lower oil prices are a positive for many Americans and for companies that will benefit from lower spending on energy. The overall impact on the economy is hard to judge though and depends on how far prices fall.

When we’ve had oil busts in the past – for all you youngsters out there go see Texas in the 80s – the impact was limited to the states most dependent on energy while the rest of the country thrived on a strong dollar and cheap oil. This time the negatives will affect a much broader slice of the economy and lot more states. As I’ve said previously, I don’t know if it will be enough to cause a recession but the pain could certainly be considerable in some areas.

We didn’t have much in the way of US economic data last week but what we had continued the previous pattern. The US economy has been growing at roughly 2% for the last three years and it hasn’t changed. We get some good data that is offset by some bad data and we end up right back where we started. What the stock market may be finally recognizing – and what the bond market has been saying all year – is that the US economy will not escape unscathed from a slowdown in the rest of the world. How much will largely determine how low stocks will go to incorporate lower economic and earnings growth. For now, I would not be surprised at all to see the market bounce soon as we are approaching some important technical levels and until we get some indication the US economy is deteriorating with the rest of the world, the optimists will still have something to hang their hat on. But watch those oil prices. They might be a slippery slope that leads directly to recession.

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