Catastrophic Decline In Oil Prices Is Bad News For The Markets

With the geographic composition of oil supply changing radically, during the second half of 2014, we saw the geo-political risk premiums getting squeezed out of oil prices. That was good. Consumers would benefit from more money in their pockets: great news for consumer discretionary and consumer staples sector. It was also good news for the high energy intensity materials sector, which would see stable demand from consumers, accompanied by margin strength as a result from lower energy costs. Industrials too would power along with margins getting stronger as energy and material costs declined. And technology would stay strong as economic strength would mean everyone would continue to hanker for productivity gains, and consumer technology would remain very much in fashion with a strong consumer. The utilities sector would stay strong with declining energy costs too, but perhaps be of less interest to investors pursuing growth. And people would joyously continue with the endless chatter keeping the telecom sector busy! The health sector would continue along its merry way with people getting sick and well regardless of the economic cycle: and while they have jobs and insurance, they continue to pay for healthcare services. The financial sector, with its parasitic character would prosper as it does while other sectors are doing well. And all of this would be very normal, for weakness in the energy sector is often a harbinger of an early cyclical recovery.

It should have been a great opportunity to churn and re-allocate capital across sectors. But it was not to be. Once oil prices hit $80 per barrel, the geo-political risk premiums were squeezed out of oil prices. But they continued to decline, mainly because it became apparent that demand growth did not get stimulated by falling oil prices - it stayed weak. So we have seen a catastrophic decline in oil prices. What should have been a virtuous cycle of growth triggered by the energy sector is likely to become a vicious cycle of despair.

We have seen dramatic cuts in capital expenditure in the energy sector. And massive job cuts announced. Job cuts are not good for consumers. The impact will show in the coming quarters, and the job cuts will not be limited to the energy sector. The cuts in energy related capital expenditure are not at all good for the material sector, which sees demand from the energy sector collapse. To add insult to injury, there is a further contraction in material demand to come from the industrial sector. Nor are the cuts in capital expenditure any good for the industrial sector, which sees demand collapse for industrial goods demanded by the materials and energy sectors. Of course some industrial sectors which are big beneficiaries of declining oil and material costs such as aerospace stay strong until falling demand from weakening consumers has an impact. Once these sectors switch to cutting costs, we should see cuts to technology spending too. Consumer technology will slow with a lag after the job cuts start hurting the consumer.

Utilities stay safe with lower energy costs, while telecom stays safe to a lesser degree, both sectors supported by lower influence from the economic cycle and steady dividends. Healthcare stays safe too, again supported by low exposure to the economic cycle and steady dividends. The consumer staples stocks, which focus on supplying necessities to the masses also remains relatively safe, again due to steady dividends and a lesser degree of cycle influence. Consumer discretionary sectors will feel the pain once the consumer cuts spending as widening job losses become apparent. The parasitic financials sector will feel the pain, as cyclical sectors weaken, particularly as credit quality weakens.

So where does that leave us? S&P 500 earnings estimates (top down) are at $121 for 2015, considerably down from a recent (December) estimate of $134. In my view, this number is still on the high side. I am looking for a considerable slowdown, with 2015 operating earnings declining to $112 for 2015.

Between 1994 and 2014, median multiples of trailing 12-month operating earnings ran as below:

If S&P estimates of $121 are achieved, using history as a guide, we could see S&P 500 at exuberance levels of 2,269, despair levels of 1,794, and an expected close level of 2,166, with the three having an average of 2,077.

If my pessimistic estimates of $112 are achieved, using history as a guide, we could see S&P 500 at exuberance levels of 2,100, despair levels of 1,661, and an expected close level of 2,006, with the three having an average of 1,922.

I suspect that the fed won't be cutting rates anytime soon, mostly on account of a deterioration of the global growth cycle together with an absence of any inflationary pressures. Barring the fed, we also have an ongoing global monetary policy easing cycle. The fed rate being on hold, coupled with a continuance of the global easing cycle will provide downside support to the market. If we see energy demand growth begin to stabilize, and prices recover to a level, which supports continued investment for production five years out, my estimates would prove to be too pessimistic. A rise in energy prices to $70 to $80 levels would remove the cap on upside. But this will only occur once demand growth normalizes.

In my view, we will almost certainly see the S&P 500 at 1,800 at some point in time during 2015. With sufficient action from the Central Banks and Governments this level could hold. It might prove to be a good time to return to your standard allocation. Without support, or with crystallization of an adverse event such as Greece being thrown to the dogs, the markets could decline to 1,650, which in my view would be a fine time to return to your standard allocation again. Late in the year, we might be looking ahead to better times in 2016, and so I would not be surprised to see a close target of 2,080 achieved.

As far as India is concerned, we could see weakness in the technology space, together with weakness in the energy and material sectors. And we will likely find that earnings expectations are currently set too high given the current low inflation and inflation expectations. I am looking for Sensex earnings of 1,512 in the year to 3/31/2015, rising to 1,700 in the year to 3/31/2016, in line with the 12% nominal GDP (roughly 5.5% to 6% inflation and 6% to 6.5% growth) I expect for the year to 3/31/2016. I look upon present Sensex levels as a great place to sell some equity to return to allocation. For the year to March 31, 2016, I am looking for an exuberance level of 34.3k, a despair level of 22.5k, and a close at 31.5k, with the three having an average of 29.4k. I don't believe that the despair level shall come into play, because I suspect we have a virtuous cycle of growth coming into play together with an easing monetary policy cycle. Yet, exuberance should be sold: a global risk on environment will likely create a dip buying opportunity from exuberance levels.