Since my last update (Feb. 26), the stock market has had its ups and downs, reflecting the push and pull of stronger economic data against higher interest rates and the ongoing political wrangling in Washington.
Stocks surged on March 1, the day after President Trump’s State of the Union speech. The S&P 500 gapped up 0.70% on the open, broke through the 2400 level and closed at 2395.96, up 1.4% on the day. Since then, the market has given back all of those gains, but it did move higher on Friday in response to a strong February jobs report.
All stock charts courtesy of StockCharts.com
Despite the recent ups and downs, the stock market has traded sideways over the past three weeks. As a result, the 14-day relative strength index (RSI), shown at the top of the above chart, has fallen back below the overbought signal level of 70. However, the RSI remains above 70 on both the weekly and monthly charts, which suggests that the market remains overbought on a longer-term basis.
Falling Energy Share Prices. There have been several potential catalysts for the market’s recent weaker performance. The most significant one, I believe, has been the sharp decline in the price of oil.
As shown above, oil, as measured by the continuous current month futures contract for West Texas Intermediate, broke sharply to the downside last week after trading sideways for most of 2017. With last week’s losses, WTI crude has broken below the $50 level and is now sitting right at its 200-day moving average.
The declines followed data which indicated that U.S. inventories had risen by 8.2 million barrels in the week ended March 8 to a record level. Oil inventories have now increased for nine consecutive weeks (and eleven out of the past twelve weeks).
The decline in crude oil prices is not entirely a U.S. phenomenon. U.S. production has been rising as a results of an expected rebalancing of the global market following OPEC’s decision to cut prices; but Brent crude has also been falling, as shown in gold behind WTIC at the top of the chart above.
The gap between Brent and WTIC widened to $3.22 per barrel on Thursday (before falling back to $2.79 on Friday), compared with an average of $2.13 over the past five months; so it seems that the downward price pressure is somewhat more severe in the U.S. Still, the decline in both Brent and WTIC raises concerns about whether OPEC is achieving its production cut targets.
It is noteworthy that energy stocks, as measured by the Energy Select SPDR Fund (XLE) shown in the bottom portion of the chart above, have been falling for most of the year, anticipating the drop in the price of oil. XLE bounced back slightly at the end of last week, even though crude oil was still falling, but it is still too early to say whether a bottom is at hand for the energy sector.
The decline in energy share prices is worrisome because of their potential impact on the overall market. Many independent exploration and development companies are still on the ropes financially after the sharp drop in oil and natural gas prices since mid-2014. The decline in energy production over the ensuing 18-20 months restrained the growth of the economy and, along with a stronger dollar, raised fears about a general decline in economic activity. (Surprisingly, both the dollar and gold fell sharply on Friday.) The drop in oil and energy stock prices held back the broader market’s performance in 2015 and was the primary catalyst for the steep stock market sell-off in early 2016.
If there is any consolation in last week’s oil price decline, it is that natural gas prices continued to rebound after two consecutive months of declines.
The rebound was likely sparked by the return of cold winter weather in the U.S. (and perhaps weather reports about an approaching late winter blizzard in the northeast). The recent rally has continued long enough to break that 2017 downtrend; but it remains to be seen whether natural gas prices will continue to rebound from here. Still, longer-term futures prices have held steady during the recent decline, so many market participants expect that the recovery in the price of natural gas will continue in the months ahead.
Interest Rates. The Federal Reserve has used the cover of both the State of the Union stock market rally and the earlier downshifting of the U.S. Treasury yield curve to signal a quarter-point increase in the Fed Funds target rate at its upcoming meeting this week.
From Feb. 24 to last Friday (Mar. 10), the yield curve shifted up about 25 basis points on average. The five-year Treasury note saw the greatest increase, up 31 basis points to 2.11; while the yield on the 10-year note rose 28 basis points to 2.58%.
Support for the Fed Funds increase comes from the generally positive data across a wide range of economic indicators in recent months. Friday’s jobs report, with its 225,000 estimated increase in payroll employment helped to seal the deal.
The increase in the Fed Funds target will serve to quiet critics who believe that the Fed should have started the process of normalizing interest rates long ago. Yet, it is noteworthy that futures markets had set the odds of a March increase in the Fed Funds rate at only about 10% just a few weeks ago. Thus, sentiment can change on a dime. Although futures markets indicate that the FOMC will raise the Fed Funds target two more times this year, the Committee will remain data dependent. The recent slide in oil prices will probably be at the top of the FOMC’s near-term watch list.
The change in interest rate expectations served to spark share price declines in interest sensitive sectors. Real estate was the worst performing market sector last week, as reflected in the 3.8% drop in the Guggenheim S&P 500 Equal Weight Real Estate ETF (EWRE). The declines were significant across most REIT sectors. (Surprisingly, homebuilders were among the strongest performing sectors last week. The Lark Research Homebuilding Stock Price Index rose 2.03% on the week, beating the declines of 0.44% in the S&P 500 and 2.07% in the Russell 2000. The rise in payroll employment, a key indicator of housing demand, more than offset concerns about rising interest rates.)
Other interest sensitive sectors posting declines last week included utilities, telecom, MLPs and food products.
Other Catalysts for the Market Decline. Other notable decliners last week included certain segments within health care (e.g. health care providers and medical equipment companies) and basic materials. The health care declines were driven by concerns about impact of the proposed replacement for the Affordable Care Act, especially on hospitals. The declines in basic materials stocks were broad-based, from paper and forest products to metals and mining. Materials stocks had enjoyed a run-up during the post-election rally, so concerns about oil and its potential negative impact on the economy probably sparked another round of profit-taking.
Conclusion. In my previous update, I suggested that the market had shifted to a “risk-off” stance, with outperformance by lower beta sectors, like utilities, telecom, consumer staples and health care, and a surprising decline in interest rates. That proved to be a head fake, as the market abruptly reversed course after the State of the Union speech, with rallies in risk-on sectors and increases in interest rates. Even so, last week’s market action suggests that the market could still shift back to risk-off mode, once the FOMC officially raises the Fed Funds target rate and especially if oil prices continue to slide.
March 12, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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