As of January 12, 2015, the S&P 500 Index is down over 3% YTD and it is the worst start to the year for the S&P 500 Index since 2009. The major news that came from overseas was the Euro zone slipped into deflation as prices in the euro zone fell 0.2% percent year-over-year in December. The plunge in energy prices is causing concerns that we might be entering a deflationary spiral. Investors are clearly unnerved by the precipitous drop in energy prices and other commodities which have historically been a reliable leading indicator of future economic growth. These indicators could be foretelling a period of slower global growth. We believe that energy prices may need to stabilize before markets become less volatile and begin to move much higher. We believe that if energy prices fall even more from these levels, corporates profits could be negatively impacted. The Federal Reserves ‘beige book’ reported this week that oil prices are causing a slowdown in areas of the country sensitive to oil prices.
As energy companies cut back on production we will sadly see layoffs as well as huge cuts in capital expenditures. Schlumberger, which is of the largest oil services company said that it will be firing 9,000 workers due to the plunging oil prices. We believe that this is just the beginning of massive layoffs in energy companies if energy prices do not rise. We believe that many energy companies will also start to announce one-time charges related to the fall in prices. On the other hand, well-run energy companies should be in a better position to gain market share and pick up assets on the cheap.
Why have markets suddenly become so volatile?
Global markets are clearly out of sync and market turbulence is now flashing in red, “fasten seatbelts”. Volatility has returned with a vengeance. The investopedia definition of a volatile market is, “an unpredictable and vigorous changes in the prices of stocks.” Our definition of volatile markets is quite different. We believe that markets become volatile when the equilibrium of the stock market gets thrown out of balance as investors become uncertain of the future. Analysts fear that consumers will hold off on purchases if they believe prices will continue to fall. Interest rates around the globe have fallen to nearly zero in many overseas countries. For example, in Germany, the 5-year bond rate actually turned negative. Deflation is the real fear. Would you place your money in the bank if they paid you less than what you put in? Your reaction would be to find the bank that would pay you the most for your money and had the best reputation for security. For an overseas investor that bank is called the US Treasury. These foreign investors who buy US Treasuries first need to sell their home currency to convert into US dollars. Hence, the result is the US dollar is now stronger than the Euro when it was first launched back on Jan 4th 1999 at 1.1789. The Euro has continued to weaken and US Treasury rates have dropped. A weak Euro is not welcome news to a US multinational company that relies on a large proportion of its sales from outside the U.S.. We believe that earnings estimates may fall for many of these multinational US companies. However, many of these same companies may see a boost in profit margins due to the lower cost of energy. We believe this quandary is confusing many investors who are trying to determine the net effects of these changes on future cash flows. This uncertainty will be a major reason why stocks may remain volatile in the near term.
Why did we anticipate a drop in energy stocks last month?
We believed the cash flows for many energy companies tied to the energy markets would drop substantially. In our last few investment updates back in November and December of last year, we warned our clients to beware the “Black Swan” in oil. We recognized major downside risks within certain industries that rely on high oil prices. We cited our favorite quote from Warren Buffett, “Risk comes from not knowing what you’re doing.” Our article a few weeks ago warned about the falling future earnings estimates of energy companies and that these companies represented a classic “value trap”. In the last week, many of these companies have fallen over 8%. Sentiment has suddenly turned extreme as investors are now focused on the short-term and they now could be missing compelling future buying opportunities. We stand ready to buy the panic. We will carefully be watching the cash flows of these companies. We believe that the managements of these companies may not be too forthcoming on their future plans but accurately reported cash flow statements may tell the true story. There is a high stakes game of poker occurring at the boards of many energy companies. Do you cut production or do you hold out and wait for your competitor to cut production. Drillers are hardwired to believe that energy prices will always go higher. Our belief is that future cash flows will be what ultimately drive these stock prices higher or lower.