What is the price of being wrong in the markets?
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
It is either loosing when you don’t need to or not getting gains when you should. Today, if you make a big bet either way, you are sure to have a sleepless night.
The elephant in the room: should I sell everything today? The answer is not one that anybody likes, which is “I don’t know.” Why don’t I know? Aren’t I the professional with experience, training and knowledge? There is some truth to that. These are the questions frustration brings to the surface. This is exactly why professional money managers need to be more responsible. They need to be honest. They need to communicate. They need to not tell the story that only supports and makes them look good and then hope that they are right so they can say “See?! Aren’t I a genius?!”
There is no doubt that there are some very strange market movements going on. It is like a wild ride at the amusement park, but this one has no definite beginning or end. All we can do is look at the facts.
Commodities are in a bear market and have been for some time. Earnings are shrinking which affects stock valuations and outlook. The Fed finally decided to raise interest rates… 7 years into a stock bull market (2 years older than average). All the other major economies are in the middle of devaluating currency while we are making ours more expensive which hurts trade, manufacturing… I promise, I am not trying to make you cry. This is why we are on the volatility rollercoaster.
The Facts: Let’s Look At Those
They are much easier to talk about and then we can get to what we should do. How are the commodity prices affecting earnings? Commodity prices have a high correlation to profits at corporations because they are leading indicators of raw inputs. If there is a lot of demand, prices go up. If not, they drop until someone is willing to buy them. This is especially true of manufacturing; manufacturers purchase raw materials to make into more useful goods to sell and they produce what is being demanded. The following chart shows the earnings of the S&P 500 and the Commodity Index. You can see that as commodity prices slumped, earnings followed.
As oil, which is the leading headline commodity taking it in the shorts for the last memorable reporting day, continues its march sharply lower, markets have followed. I think at this point the market is at a point where until they see stability in the oil market, there isn’t going to be stability in the equity markets. Again, this is not a controversial statement today.
This next bit may be more controversial, but the evidence supports it. The Fed, keeping rates abnormally low far past the end of the last recession have resulted in a big commodity bubble that began bursting last year. This is one of the big reasons why we didn’t ever fully buy into the “recovery” last fall. All the commodity prices were still dropping. The following chart shows the Fed actions plotted with the commodity prices.
It is a little bit of a noisy chart, but you can see that when monetary policy was kept too easy (low interest rates) too long the commodity prices spiked. They got overinflated in 2008 and popped. Then, kept easy past the recession they grew again (although not as high) and certainly have slumped (ok dumped). The concern right now and perhaps even a fear of the fed is that this indicates rates are now not too high, but too low.
Uh-oh. A new battle has begun but the Fed doesn’t have any bullets. Here is a plot of all the commodities versus the oil. I think it is important to see how they relate since the thesis above somewhat rests on whether or not we really can look at oil to get an idea of the commodities in general.
It isn’t perfect, but it is more or less similar. One thing that nobody is arguing about is the fact that commodity prices are lower.
If the earnings expectations from 4th quarter 2015 are higher than they are actually reported (we are right now in the 4th quarter 2015 earnings season), that means people are likely to keep selling pressure up. If they all come in above consensus expectations, we may see a rally.
The following is a chart that plots risk of selling off further due to earnings misses. This is broken down by sector and is projected out for this earnings season and the next earnings season. The red indicates those that are likely to cause the most selling or buying in best and worst case scenarios and the green are the least to worry about.
Lots of data. What do we do?
We need to remain cautious and resist the temptation to react emotionally. That is really the hardest thing to do but it could be very helpful to at least talk about what expectations are. We have been very pleased with how our tactical strategies have been holding up and how not fighting the Fed but at the same time remaining cautious and not taking big bets has preserved capital in this downturn.
Should this prove to be more than a downturn (data puts that at nearly 50/50), we are ready and prepared to continue to protect assets. Should markets jump up and take off like a cat who just saw my dog, we are ready and prepared to put money back to work where it makes sense (since August 2015 it hasn’t made sense to take any big bet on the market).
This doesn’t mean we can time the ultimate low or ultimate high. This means we are not sleeping on the job, we are actively looking at the risks of the market and each market segment and we are navigating together through rough seas.
We will come out on the other side and we intend to get you there safely. We are committed to our clients, to being honest and using every tool and all the technical and fundamental knowledge we have, to do the best work for you that we possibly can.
BCJ FG 16-13
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