The world is kind of maybe about to go to sh*t.
Investors hit the panic button recently, as the Dow and S&P plunged dangerously. Both the stock market indices had their worst ever week in 4 years. The S&P 500 dropped 7.6%, teetering on the brink of full-blown market correction territory.
Why is this happening? WHHHHYYY?
Aren’t we supposed to be recovering from the worst recession in generations? Isn’t it supposed to be all puppies and rainbows from here on out?
If you were looking, the signs were there. The question on everyone’s mind: is the bottom going to fall out?
Hard to say. It’s always hard to say. But here’s what we do know.
We’re reaching the end of a Fed-driven stock rally. The Federal Reserve have so far propped up the market through quantitative easing measures. Basically, the Fed buys up as many U.S. government bonds as they can get their hands on. This creates a bunch of artificial demand for U.S. treasuries. When a good is highly demanded, we tend to see its price rise, right?
Well when bond prices rise, the yield (how much you can earn on that bond) goes down. So if you are in the business of making money and your ability to do that in the bond market is diminished…what do you do? You move into equities. And that’s exactly what people have been doing.
So, picture it. We’ve got the stock market building up, making higher highs and scaling tall buildings in a single bound – but it’s all a bit…artificial. Then the entity that’s been buying all the Treasuries tells you that they will stop their purchases. They say they’re done supporting the stock market.
Cheap oil, the strong dollar and the China stock crash are all having an impact on the global economy. Add in what’s happening with the emerging markets and the euro area and it doesn’t really seem like there’s a place in the world that’s doing well. There’s no place to hide.
Oil prices made the briefest of recoveries before deciding that rising in value was just a thing it was trying out for the summer. Crude oil prices actually broke below $40 a barrel which…is nuts. As Jeff Gundlach, the “bond king”, said that if oil goes to $40 a barrel then “something is very, very wrong with the world – not just the economy”.
So you’re thinking, what’s so bad about having cheap oil?
But cheap oil is good for me, isn’t it?
Well, yeah…but it’s not good for oil companies. There are big oil companies that have made some expensive bets and the bookmakers have come calling. Oil companies produce oil at different break-even prices. The break-even price is the amount they need to charge per barrel in order to break even on the costs of getting that black gold out of the ground. If it costs them $60/barrel then they can only afford to stay in business for so long.
If oil has the potential to wreak havoc, then consider the continued strength of the U.S. dollar. The dollar was always healthy and super into working out, but has seriously ‘roided out in recent times. A few years ago, one euro was worth as much as $1.37. It fell recently to $1.05 before bouncing slightly. So the question becomes: how can U.S. public companies, for whom an ever-increasing share of profits come from overseas, grow their earnings when the dollar is working against them?
Nearly half of U.S. corporate earnings come from outside of the U.S. and the money they earn offshore is worth less as the dollar bulks up. The irony is that strength in the dollar often represents one of two things: confidence in the U.S. or pessimism about the rest of the world. The pessimism is well-warranted but it seems that any confidence in the U.S. might be misplaced. Or it’s simply a case of a collective shoulder shrug amongst investors and a unified “well, where else would we put our money?”
Then there’s Chinese stock crash that took down many other emerging markets along with it. The bubble burst back in June and the Shanghai index lost a third of its value. China then unexpectedly devalued their currency (which is usually fixed to a certain point) and, as if to make matters worse – there was a Manufacturing indicator (Chinese PMI) that came out telling the world that the Chinese economy was weaker than they had previously thought. That sort of information makes people nervous, very nervous. Nervous investors have itchy trigger fingers.
As China devalued their currencies, other emerging markets followed suit. It’s like if you’re a vendor on a street market and the guy next to you starts offering a discount on strawberries. If you also sell strawberries you might consider lowering your prices in order to stay competitive. That’s what’s happening right now. China and many of the emerging markets sell strawberries (i.e. they sell the same products). Weakness in emerging market currencies only results in more relative U.S. dollar strength.
This is the current backdrop against which investors are angling for decent returns and value in the market. It doesn’t make for inspirational reading.
If oil prices persist in dancing the limbo (how low can you go?) then companies are going to start defaulting on their debt. You may not see it today, you may not see it tomorrow. But it’ll happen. Defaults can take time to materialize – a firm can engage in extra rounds of funding (essentially taking out debt on their debt) and prolong the death knell, but ultimately the price of oil will determine their fate.
Defaults are the financial system’s way of shaking off the cobwebs.
When defaults don’t occur, money just gets shifted around – kind of like a weird global shell game. The new lows in the Dow and S&P 500 are likely the result of shifting money. People are taking their chips off the table, moving money from stocks to cash. Or bonds. Or into their piggy banks.
If that happens, the factors described above mean that a global crisis is in the cards. Recovery will be…incredibly difficult, to say the least. A global economy that is relying on the (in reality, very muted) economic strength of the U.S. might find that things are about to get real ugly.
To learn more about what’s going on with the stock market and how to best protect yourself, head on over to Wall Street Survivor.