Yesterday was Easy: When Unknowns Were Really Unknown

Market moodiness continues as the S&P 500 has gyrated more than ten points during nine of the last ten trading sessions and, as of Tuesday’s close, all the major stock indices have fallen back into the red for the year, with the S&P500 down 2.34%.

The market has been tripped up by the general flop of economic growth (nine months running) almost everywhere apart from the U.S.  There has been the disruptive, initial effect of oil prices for producers as well as the general boosting of disinflationary expectations.  And, as imagined, we now have deafening protests with regards to Europe’s woes and the “when’s” and “how’s” will growth finally recover?

This whirlpool of worry is precisely why we have witnessed a collapse in interest rate yields (10-year UST 1.82%) along with a universal re-rating of risk assets. All things considered, stocks have done reasonably well tolerating a persistently determined downfall in petroleum prices. So far in 2015 (all 14 days of it), WTI prices are down 15%, the U.S. dollar recently extended itself to nine-year highs against the Euro while commodity markets split keeping base metals on their heels (copper – 11.93%), and precious metals appear to be benefiting from a hint of diversification demand as gold is up 3.18% and platinum up 2.18%.

The “Known Unknowns”

Today, there are far too many macro questions looming for prices to meaningfully respond.  Vaguely reminiscent to 2014, questions linger and include: How does Draghi intend on preparing the markets for ECB action or the lack thereof?  Will the U.S. Fed really begin hiking rates in June and, if so, how will the markets respond? Will any of the major oil producers “cave” and start adjusting the free-flow?  What will be the medium-term impact of the crude crunch, and will it ultimately cause credit market disruptions?  How much longer can the U.S economic engine continue to pull unassisted?

While the issues above appear both well-known and well-worn there appears a stark difference in the most recent market composure.  Why are the “known-unknowns” causing so much volatility?

Oil- Changing Fortunes and Episodic Events

Textbooks teach that normalization (i.e. bottoming out) in commodity price cycles occur when supply begins to fall either inadvertently or intentionally. However, oil is a commodity that often, and for disturbingly extended stretches of time, refuses conformity to the very basics of schoolbook economics (e.g. trading well above its “cost-curve” for 12+ years) let alone convention or common sense.

At its innermost core, oil is a political commodity, a country of sorts that’s history encompasses countless kings and kingdoms – its value ebbing and flowing grounded on the fear or assurance of those governments.

Consensus initially rejected the oversupply notion relegating headlines proclaiming Iraq and Russia flooding the Black Sea market, production growth in the Permian and Eagle Ford regions, and Nigeria having difficulty moving cargo - to the back pages of the paper.  However, like fresh snowfall on a sledding hill, the sledding was initially cumbersome until the grooves proved deep and slick – now everyone believes the same sermon (oversupply) as consensus glides down the same track rapidly together with little fear of hitting a tree.

The demand story has been otherwise crunchy – a classic “whisper down the lane” game – as reports vary on Chinese product demand (i.e. diesel flat, jet fuel up), Latin Americas reduction in oil price subsidizes offset any demand increase due to lower prices, OECD inventories are filled to the gills, and India nor Indonesia have yet to show deference to this lower price.

When Will the Coast be Clear?

The current worry list is both deep and dark and evokes dank imagery of the German Romantic artist Caspar David Friedrich’s 1818 painting, “Wanderer above the Sea Fog”. We are surrounded by desperate proportions of headline haze and it’s incredibly difficult to think or navigate beyond the two feet in front of our faces.

Front-porch wisdom tells me the best cure for lower prices is indeed lower prices!  In the case of oil, the lower the price, the sooner production growth will (eventually) slow down as the lower price will force producers to cut-back on capital expenditures and E&P, resulting in a swifter response time.  This sounds good on paper however, it’s profoundly confusing as the speed of the price loss must – at some point – be harmonized by the justifiability of that price – otherwise producers will simply persist.

Growth jolts, policy angst and civic unrest aside, oil will eventually normalize – not because it must or it always has/does but, due to simple supply vs. demand economics.  And markets – unsettled as they appear – will get back to basics of following inherent fundamentals once they receive a premonition of supply meeting demand.

Markets like weather and/or life in general move on – and breathtakingly quickly at that.  Tired of the winter blizzards?  Just wait.  Weary of the summer heat?  Wait a minute.  The one thing I should think we do not want to do is drag the wood, hay, and stubble of a thousand reasons on why or when – especially as in years to come you’ll kick yourself to think you had paid them any mind at all.