February 28, 2016 Crystal Ball

Risk/Reward Vol. 297

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“You babe, steppin' out
Into the night
Into the light”---lyrics from “Steppin’ Out” sung by Joe Jackson

“Oh I've felt that fire and I've been burned
But I wouldn't trade the pain for what I've learned
Of the cracks in the crystal, the cracks in the crystal ball”---lyrics from “Crystal Ball” sung by Pink

“I've been saving all my money just to take you there
I smell the garden in your hair”---lyrics from “Marrakesh Express” sung by Crosby, Stills and Nash

Once again this week, the price of oil and the two major stock indices were lock “steppin” up and down; “into the night/then into the light.” If you doubt this correlation, take a look at Wednesday’s action. In the morning, the price of oil sank below $30/bbl. on news from the Saudi minister of oil that OPEC would not cut production. The drop in the price of oil caused the Dow Jones Industrial Average (DJIA) to sink 267 points. That afternoon, the Energy Information Agency announced that gasoline inventories had fallen for the week. The price of oil jumped $2/bbl., and the DJIA rebounded 320 points to close the day up 53. Is this correlation logical? How long will it last? Logical or not, it exists. And it will continue to exist until it doesn’t. This is the current state of the market, and this is why I remain mostly in cash.

As loyal readers know, I study the factors that affect the yield on the benchmark 10 Year US Treasury Bond; the yield to which my favorite securities (preferred stock, REIT’s, BDC’s, etc.) are correlated; the yield that is my “crystal ball.” Every time that I misread the signals impacting the 10Year, I “feel the fire and I get burned.” That said, “I wouldn’t trade the pain for what I’ve learned.” So what do I see? Before Friday, all inputs signaled that the yield on the 10Year would remain indefinitely below 2%, where it has resided since the end of January. Forward interest rate indicators (e.g. the 5 Year TIPS breakeven and the 5 Year/5Year Forward) were both well below 2%. But on Friday, the Commerce Department released personal consumer expenditure (PCE) numbers (the Federal Reserve Open Market Committee’s (FOMC) favorite inflation index) which showed that year over year core inflation (that which excludes food and fuel) was at 1.7% in January; not that far from the Fed’s target of 2%. These numbers do not change my opinion that no rate hike will occur in March, but they do increase the odds of a June rate hike from 25 to 34%, at least according to the futures market. I continue to like interest rate sensitive stocks, but if other indications of inflation appear, I may exit some positions.

Speaking of interest rates, it was refreshing to hear FOMC member, James Bullard, admit on Thursday’s Squawk Box telecast that the past several years of low interest rates have deprived an entire generation of a decent return on savings. Since 2008, an investor has had no chance of visiting Marrakesh or any other locale where one “can smell the garden in one’s hair” if he has merely “saved all his money just to take you there.” Reward has come only with risks that previous generations of savers have not had to face; risks inherent in equities and lower rated bonds. But, alas, fellow savers, do not look for rates to normalize. News from yesterday’s G-20 meeting confirms that the world’s central bankers will not change their easy money, low interest rate policies any time soon.

Another week has passed, and “Déjà Vu”, the correlation between the price of oil and the stock indices “Carries On.” Directionally, that has been upward these past two weeks. Reports on Friday indicate that the number of domestic oil rigs in operation has dropped to 400 from a high of 1600 in October, 2014. Is this enough information for me to significantly increase my exposure to stock? No, not until I see more stability in the price of oil. I stated so several weeks ago, and I stand by that statement. After all, in the words of CSN, “one must have a code that you can live by.”