Wall Street’s favorite mean reverting indicator has fallen far from the mean. The S&P 500 Volatility Index, or VIX, rose to over 19 on Thursday after falling below 12 earlier in December. Complacency about a bullish December for U.S. stocks on improving economic indicators evaporated, with concerns offsetting a number of bullish economic reports.
The good news is almost all domestic. Retail sales rose 0.7%, unemployment claims are down to their lowest levels since January 2000, and services revenues are up 5% year-over-year. Cheap oil is almost sure to cause more spending, which encouraged many analysts to upgrade their GDP expectations for the fourth quarter. Now 4.2% annualized growth is likely, and the cheap energy is a main cause of the growth.
The impact of this growth is clear: rising revenues and cheap credit should help earnings per share to rise for this year’s earning’s season, especially for consumer-facing industries like consumer discretionary (XLY), retail (XRT), services (IYC), and travel (XTN). Already airlines (LUV, JBLU) have benefitted, as cheap oil is sure to raise their profitability considerably.
With all of this good news, one would expect little fear in the market, but the VIX has still risen over 50% in a couple weeks. The problem comes from a variety of factors, which can be listed one-by-one:
- Energy-related debt defaults – High yield yields have fallen for a long time, and high yield debt prices have risen. This is mostly driven by a large amount of capital looking for a return as U.S. Treasury and developed nation bond yields are just too low. This has caused a lot of money to go to energy producing companies and countries. While that’s fine when oil is expensive, when it’s cheap and unprofitable to produce, that could result in debt defaults. That possibility is spooking markets, causing high yield debt (HYG, JNK) to fall. It’s also causing greater panic in energy stocks (BP, CVX, XOM) and in the market as a whole.
- Cheap oil and emerging market uncertainty – Cheap oil is great for America, but not for emerging markets that depend on oil for revenue. How will Venezuela, Qatar, Saudi Arabia, or Russia cope with unprofitable or low margin oil production? Can they? Will these countries default—or have unrest? Is this the beginning of a new period of global poverty and desperation? How does this impact American companies, which are growing more dependent on emerging markets for revenue growth? These are hard questions, and remain mostly unanswered. For that reason, many think it’s best to take some money off the table.
- China’s tightening – China recently announced that lower quality bonds cannot be used as collateral by certain entities. This means it will be harder to borrow money in China, which in turn will cool down Chinese growth. This move was necessary, as default rates in China were rising. But it also means less growth in the future for all companies, including U.S. companies investing in China’s emerging middle class. The impact of this on the U.S. is uncertain, but worrying; again, a cause to divest.
- Japan’s recession – Japan’s weakness was well understood, but it’s even weaker than previously expected. An upcoming election and disappointing GDP numbers mean that the future of Abenomics and liquidity from Japan put the whole momentum of Japanese and U.S. stocks in question. If monetary easing is going to stop in Japan, stocks will get hit very hard. This is unlikely, but more possible than before, so it’s again a reason to put a bit more into cash.
While the cheap oil is certainly a boon to net importers and consumers like the United States, it is not without risks, which is causing fear in the market. The upside is well known and easy to price in, but global instability and falling liquidity are much harder to measure and understand; we can predict changes to P/E ratios pretty easily, but predicting whether cheap oil will lead to a civil war in Venezuela is not so easy. Thus, for now, the market is deciding to be a little more fearful, and a little less greedy.