Financial markets, already stressed from the coronavirus drama of recent weeks, received another stiff challenge this weekend, this time from the oil markets.
The simplified version of what's going on is this: Saudi Arabia, Russia, and the United States are the biggest oil producers in the world at this point. Last week, OPEC ("led" by Saudi Arabia) and Russia engaged in a high-stakes game of chicken regarding production cuts designed to support prices in a coronavirus world of declining demand. In a bit of game theory, both the Saudis and Russians stood to gain if the other would back down, but both stood to lose if neither would yield. Which is precisely what happened.
Unpacking the oil price cut
It's a bit unclear how much of this is motivated by Russia's (and potentially the Saudi's) desire to tighten the screws on U.S. shale producers, who have become a significant pain in the neck for both countries as the U.S. has remarkably risen to become the world's top oil producer in recent years. But whatever the motivation, when Russia refused to meet the production goals pushed by the Saudis, the Saudis responded with both deep price cuts and increases to their own production. And the price war was on.
So why is this a big deal to global financial markets? Aren't lower oil prices generally a good thing for struggling economies and consumers?
The markets certainly didn't take it that way, as it took all of four minutes this morning for U.S. stocks to hit their -7% circuit breakers, which halted trading for 15 minutes. Let's unpack why the market reaction was so severe.
First, it's clearly not just the oil price war roiling the markets this morning. It's that added uncertainty on top of what was already massive uncertainty surrounding the scope and extent of the coronavirus as a health issue as well as a future economic issue. When a few billion people suddenly start reevaluating every decision from going out to eat, to business travel, to canceling any and all future vacations, to even whether they will be allowed to go to work a week from now, the threat to future economic activity becomes clear.
Second, while lower oil prices generally have been viewed as a boon to U.S. consumers and the U.S. economy in the past, that equation has shifted in recent years as the size of our energy industry has soared. Now, any benefits of lower oil prices have to be weighed against the negatives a prolonged slowdown in energy activity would impose on U.S. energy companies. This means layoffs, lost wages, and so on. With this deep cut in oil prices, the risk of a U.S. recession likely just went up.
In addition to a higher likelihood of recession, the third reason the financial markets went haywire on this news is its potential impact on the credit markets. The energy sector is highly leveraged, which is a fancy way of saying energy companies carry a lot of debt. What Russia seems to be banking on is that lower prices will make it hard for many of these companies to make their debt payments, which could drive them out of business. That's a real possibility. But it doesn't necessarily mean a production void would be created that Russia could fill, which seems to be their hope. More likely is that weaker players in the U.S. shale industry would be shaken out and stronger players would obtain those assets and emerge in better shape overall. It's not as if the actual oil is going to disappear from U.S. basins. It's just a matter of who is going to pump it, when, and for how much profit.
Unfortunately, the impact on the credit markets isn't limited to the specific U.S. shale firms. Those firms owe money to financial institutions, whose likelihood of being repaid just took a major hit. This effect is true all over the globe, by the way, which is one reason bank stocks are getting hit hard all over today. In addition, while energy makes up just about 3% of the S&P 500 index, those firms represent roughly 10% of the "junk" bond market. These high-yield bonds are considered risky enough to be labeled non-investment grade, but high yield bonds still represent a huge proportion of the U.S. corporate debt markets.
How to respond to the market upheaval
Today is the 11th anniversary of the exact Financial Crisis low on March 9, 2009. Most investors date the recent bull market in stocks to that date.
For perspective, this is the fourth decline of roughly this depth the market has experienced in those 11 years. We had a -16% drop in 2010, a -19.4% drop in 2011, a -19.8% drop in 2018, and now we have this (as I write) -18.2% drop. Each of the prior three were fairly terrifying at the time as well.
What those three past corrections had in common was none turned into episodes where the U.S. economy slipped into recession. That distinction matters and is the most significant question surrounding the current market crisis. If the U.S. economy can successfully avoid a recession once again, there's a very good chance this downturn may not go much further. Unfortunately, it's incredibly difficult to forecast that right now, largely because there are so many questions surrounding what the coming weeks will look like in terms of the coronavirus.
Whether a recession occurs does matter, as the deeper bear markets in history have tended to result from recessions that occurred when stock prices were elevated. SMI has been warning about this for well over a year, so hopefully SMI readers and listeners came into this with reasonable allocations.
SMI members have long been encouraged to allocate significantly to our Dynamic Asset Allocation strategy, which turned very conservative a month before the market downturn started. This has been a huge help, both financially and emotionally, as the events of recent weeks have unfolded!
However, even if you've not been using the SMI strategies to this point, there's still reason for hope.
First, if you're a younger investor — and by that I mean anyone under age 50-55 — you need to push through the current panic in the market and recognize that for younger investors, bear markets are usually a good thing. I know they don't feel like a good thing, and the temporary damage they can cause to a stock-heavy portfolio statement sure seems real. But for those in the portfolio accumulation phase, the ability to buy significantly more stock with each regular 401(k) or IRA contribution is a huge benefit. Don't stop making those contributions because of the current market fear — those dollars are stretching farther than ever right now!
Second, if you're a "not younger investor," all is not necessarily lost for you either. Hopefully, you've heeded our counsel to allocate increasingly to bonds at your later investment stage. If so, you're probably in better shape than you realize. That's because as poorly as stocks have performed the past few weeks, bond returns have been fantastic. The typical 60/40 stock/bond portfolio (U.S. only) is only down a little over -5% year-to-date. As scary as the headlines have been, I think most investors would be relieved to find their losses are that shallow. From that still-reasonable point, you may want to consider adding some of the downside protection offered by SMI's strategies.
As always, our counsel is to have a good long-term plan and stick to that long-term plan. That's especially true during times like these when the markets are wild and investors are most vulnerable to going off-script and making decisions they regret later. If you've already got a good SMI-based plan, take a deep breath, and pray from the Scriptures below before you take any further action. And if you don't yet have a good SMI-based plan, we would strongly encourage you to quickly change that and put one in place.
James 1:5 — If any of you lacks wisdom, you should ask God, who gives generously to all without finding fault, and it will be given to you.
Philippians 4: 6-7 — Be anxious for nothing, but in everything by prayer and supplication, with thanksgiving, let your requests be made known to God; and the peace of God, which surpasses all understanding, will guard your hearts and minds through Christ Jesus.