Plunging oil prices rattle the stock market

Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stock-picker. – Peter Lynch

After seven consecutive weeks of stock market gains, the major averages were overdue for a pullback and the plunging price of oil provided the catalyst for broad-based declines in stock prices. It was a week to forget as the stock market suffered its worst loss in more than three years as the price of oil settled at $57.81 a barrel, its lowest price in over five years and a drop of 46% from the 52-week high set back in June. It’s been a perfect storm for oil as excess supply, weak global growth and the refusal of OPEC and other oil producers to cut production in order to maintain their market share have all contributed to the downward spiral in prices. Many investors are uncertain whether or not lower oil prices should be viewed as a positive or a negative when evaluating their effect on the global economy and the stock market. On the one hand, the energy sector is responsible for a large percentage of capital expenditures that suddenly do not make economic sense with the price of oil at such low levels. With slower growth in China and pervasive weakness in Europe, declining oil prices may also be an ominous sign that portends slower growth for the U.S. next year. Conversely, low gasoline prices provide the same benefit as a tax cut and consumers should reap the rewards by having more money at their disposal for discretionary purchases. Consumer spending accounts for about two-thirds of gross domestic product (GDP) and cheaper gas should provide the tailwind that boosts economic growth. This fact was confirmed last week as retail sales for November were strong and consumers were as confident as they have been in eight years according to a recent survey. While this tug of war may continue near-term, the positives of low oil prices outweigh the negatives and should benefit both the economy and stocks over the longer-term.

Last Week

The news from China last week was worrisome and added to investor concerns. China’s exports rose only 4.7% in November, down from an 11% increase in October, and industrial production also came in below expectations. Regulators in China banned investors from using low-grade corporate debt as collateral to borrow money, a sign that economic growth is likely to slow after years of using debt to finance high growth levels.

In the U.S., retail sales for November rose 0.7%, which was the fastest rate of growth in eight months and optimistic news after other reports showed disappointing shopping results last month. The labor market continued to improve as jobless claims fell and the producer price index (PPI) fell 0.2% due primarily to the drop in oil prices.

For the week, the Dow Jones Industrial Average lost 3.8% to close at 17,320 while the S&P 500 Index fell 3.5% to close at 2,002. The Nasdaq Composite Index dropped 2.7% to close at 4,653.

This Week

The highlight this week will be the Federal Open Market Committee meeting as the Fed will release new data on its financial and economic forecasts as well as announce any changes in monetary policy. Investors will want to see whether or not any changes are made in the language regarding the Fed’s intention to keep interest rates low for a “considerable time.”

The consumer price index (CPI) for November should show a modest decline while the November leading economic indicators should show a healthy increase and confirm an improving economy.

The most notable companies expected to report earnings this week include Oracle, Accenture, FedEx, General Mills, Con Agra Foods, Nike Inc. and Carnival.

Portfolio Strategy

Despite the drubbing the stock market suffered last week, the S&P 500 is still up about 10.5% on a total return basis this year. Although high yield bonds also dropped in value as oil prices plunged, the yield on the 10-year Treasury slipped to 2.10% as government and investment grade corporate bond prices rose. Intermediate-term bonds and bond funds have posted year-to-date returns of between 5% and 7%, which is an attractive return considering their lower level of risk. Falling oil prices and slowing economic growth overseas have caused investors to again reevaluate the inflation outlook and the timing of a possible interest rate hike by the Federal Reserve. For this reason, this week’s FOMC meeting will take on added importance as investors attempt to gauge any change in policy. The swift and steep decline in oil prices has created a lot of uncertainty and unnerved investors about the near-term direction of stock prices. After investors realize that the benefits of low oil prices far exceed the costs, the stock market should regain its footing and continue to perform well. Although this bull market is approaching six years in length, the economic fundamentals and corporate earnings outlook as well as the scarcity of attractive alternative investments suggest that U.S. stocks have further upside potential as investors look ahead to 2015.