Stock prices have been all over the map so far this year. And some investors think the increase in volatility is a warning sign that the market is on the verge of collapse.
Yeah, I know… we’re only in the second week of 2015. It’s a little premature to make any sweeping judgments about the health of the stock market based on eight trading days.
But then again, the average daily price range for stock prices is 50% higher than it was last year…
Stock prices don’t usually make big moves during the trading day. The vast majority of stock price movement occurs between one day’s market close and the next day’s open. Companies usually release news when the stock market is closed, leaving investors to decide how any new developments will affect the company’s value during the off hours.
That’s why you often see a stock open the trading day with a large price move. These are called “gaps.” When you see price gaps at the open, it means stocks are reacting to news.
But that’s not what we’ve been seeing so far this year. We’ve been seeing mostly flat opens and then large price movement during the trading day.
That means investors are not reacting to news so much as price action. And that can be pretty darn unpredictable.
Making Sense of the Madness
When prices start reacting to prices instead of fundamentals, you might as well flip a coin to decide the direction in which prices will move in the near term.
Like yesterday, we saw a strong gap higher for the Dow Industrials, which had that group trading darn near 300 points higher at 17,900 around 10:00 a.m.
Then the bottom fell out, and stock prices started plunging. By 2:30 p.m., the Dow Industrials were down nearly 150 points. Do the math: The Dow Industrials made a 450-point reversal from highs to lows.
Normally, you might guess that some terrible bit of news hit the wires and caused an all-out panic…
But that’s not what happened.
It was oil. Again.
For the last couple of years, American oil companies’ ability to tap shale oil has been a godsend. It’s put people to work, increased corporate spending, and lowered the U.S. trade balance.
Goldman Sachs estimates that capital expenditures by U.S. oil companies account for over a third of total spending by the companies on the S&P 500.
That’s a lot. And it shows how much oil companies have been spending to grow and how little other companies are spending on growth. (Instead, most S&P 500 companies are spending their cash on higher dividends and share buybacks — which is good for investors but doesn’t do a lot for economic growth.)
But now that oil prices have fallen into the $40s — unthinkable just a few months ago — investors are worried about the impact of oil prices on the overall market and the economy.
Lower Earnings
Right now, the biggest concern is S&P 500 earnings. First quarter earnings estimates have already been lowered by 6%.
I had a running estimate from December that the weakness in oil prices would lower earnings by 4% to 5%, so 6% is in the ballpark. But again, this move is just on estimates. The fear is that the impact on actual earnings will be worse.
The P/E for the S&P 500 right now is 19, according to the Wall Street Journal. By any measure, that’s on the high side. Of course, if earnings are posting solid growth, perhaps there’s a scenario where stocks grow into their valuations.
But with falling oil prices, that’s not what investors are worried about…
The drop in first quarter earnings estimates wipes out much of the anticipated earnings growth for this quarter and perhaps for the year. For instance, current estimates suggest 2% profit growth for the first quarter. In October, analysts were expecting 9% earnings growth.
That’s a big change, and it’s the most important factor behind the downside action, in my opinion. Investors want growth. They want to see earnings and the economy grow. It is this growth that supports rising stock prices.
Ultimately, it doesn’t matter why you lose growth. It’s a simple formula: lower growth = lower stock prices.
That’s the bearish angle.
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But as usual, there is a bullish angle. Lower oil prices have the potential to boost consumer spending — and corporate profits — in other areas, like consumer discretionary.
After all, the Energy Department estimates the average U.S. household will save $750 on gasoline this year. And since the U.S. economy is 70% consumer spending, the increase in spending could more than offset the profit loss from oil companies.
And that scenario — rising consumer demand — could lead to a rise in hiring and wages.
The problem with this bullish scenario is that it will probably take a little while to play out. In the meantime, the painful fall in oil is right there for everyone to see.
Where’s the Bottom?
So where’s the bottom for oil and stock prices?
Well, I get the sense we are close to a bottom — for oil, anyway. If you’ve been following the commentary surrounding oil prices, you’ve noticed the increasing negativity.
A month ago, it was, “Oil could fall to the mid-$60s.”
Then it was, “Oil could break below $50.”
Now, we have people saying oil will head into the $30s. Saudi Arabia says oil will never see $100 again. And I even saw one suggestion that oil prices will trade down to $13 a barrel!
This bearish hype is no different than the bullish hype you see at stock market peaks.
And it suggests to me that we are probably pretty close to a bottom for oil prices. So here’s what to look for…
When prices bottom out, you usually see what’s called a capitulation day. “Capitulation” means giving up. And a capitulation day is where the last oil holdouts give up and sell.
That leads to a big intra-day drop in oil stock prices. And this drop has a tendency to reverse to the upside pretty quickly. Remember: bottoms are V-shaped; tops are a process.
Be on the lookout for a sharp drop in oil stock prices, with oil prices themselves also making a big move lower. That will be the signal that the decline for the broader market is over.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
