Stocks drop on weak oil prices, retail sales

Investing without research is like playing stud poker without looking at the cards. – Peter Lynch

The stock market broke a five session losing streak on Friday but it wasn’t enough to overcome another negative week as the S&P 500 Index dropped over 1% on weak retail sales and lower oil prices. While stocks are only down modestly from their all-time highs, it appears that volatility will be the rule rather than the exception for 2015 if the first two weeks of the year are any indication. As the price of oil declined below $45 a barrel, investors again struggled with whether or not low oil prices would help or hurt U.S. equities. While the plunge in energy prices is primarily a reflection of oversupply, weak global demand for oil is also part of the equation. This worry manifested itself last week as December retail sales fell 0.9%, much worse than expected, and raised concern that economic growth will be weaker than first thought. Even after stripping out the effects of gasoline, autos, food services and building materials, core retail sales dropped 0.4%. This data came as a surprise to most economists who felt that lower gasoline prices would act like a tax cut and translate into higher consumer spending. The beginning of fourth quarter earnings season also failed to give stocks a lift. Although Alcoa kicked off the earnings confessional with better than expected revenue and earnings, the big money center banks such as JP Morgan, Citigroup, Bank of America and Goldman Sachs disappointed investors with lower trading revenue and profits. Banks have also been adversely affected by steadily declining interest rates as they have seen their interest rate margins compress. With a list of companies that is representative of all S&P 500 industry groups scheduled to report earnings this week, investors will get a much better picture of the effect of lower oil prices on company earnings. These results could hold the key in determining the near-term direction of stock prices.

Last Week

In tandem with falling oil prices, both the producer price index (PPI) and consumer price index (CPI) fell more than expected in December. The PPI dropped 0.3%, the biggest decline since October 2011, while the CPI fell 0.4%, the biggest drop in six years. Excluding the volatile food and energy components, the core CPI for the last twelve months has risen 1.6%, below the Federal Reserve inflation target of 2%. While the National Retail Federation reported that holiday sales rose 4%, many retailers fared poorly as they offered sharp discounts to attract customers, hurting their bottom line. An index of small business optimism reached its highest level in over six years, bolstered by increased sales expectations, hiring and business expansion plans. A measure of consumer sentiment also soared, a positive sign for the economy.

In an unexpected move, Switzerland’s central bank ended its exchange-rate cap with the euro and the Swiss franc soared as interest rates on deposits fell into negative territory. The European Central Bank (ECB) is widely expected to implement a broad-based asset purchase program this week to help stimulate its economy. This move by the Swiss was designed to counter a likely move by the ECB.

For the week, the Dow Jones Industrial Average dropped 1.3% to close at 17,511 while the S&P 500 Index also lost 1.3% to close at 2,019. The Nasdaq Composite Index skidded 1.5% to close at 4,634.

 This Week

With both the stock and bond markets closed on Monday for Martin Luther King Jr. Day, the most anticipated news event of the week will be the ECB meeting on Thursday, which should bring a new round of quantitative easing. China will also release a slew of economic data this week, including GDP for the fourth quarter, industrial production and retail sales. GDP growth is expected to be slightly above 7%. In the U.S., both December housing starts and existing home sales should confirm an improving housing sector while leading economic indicators for December should register a healthy increase.

Companies in all sectors of the S&P 500 Index will be represented on the earnings calendar this week. Among the most prominent include Halliburton, IBM, Johnson & Johnson, Verizon, McDonald’s, General Electric, Union Pacific, American Express and Morgan Stanley.

Portfolio Strategy

Although it is difficult to quantify, the effect of low oil prices on S&P 500 revenue and earnings growth could be substantial. After adjusting for weaker energy sector profits, forecasts for corporate earnings growth this year are in the 5% to 8% range. Corporate balance sheets are in excellent shape with a lot of liquidity and stock buybacks and dividend increases should continue to be strong. While low oil prices should ultimately provide a boost to economic growth, there will be a lag effect and benefits will occur over time. A strong dollar could hurt profits of multi-national companies that export their products overseas by making their goods more expensive but that same strong dollar should help keep inflation low. That, coupled with low energy prices and lack of wage growth in the labor market, could enable the Federal Reserve to postpone any interest rate hikes until the fall or possibly later. Though the S&P 500 is currently reasonably valued based on projected earnings for this year, the relationship between earnings yields and bond yields is still favorable for equities, especially as the 10-year Treasury yield has sunk to 1.83%. Compared to near-zero yields on money market funds and miniscule yields on short and intermediate-term Treasuries, a total return of 5% to 8% on equities for the year seems downright attractive and entirely possible. The wild card may well be what effect further stimulus measures have on European economic growth and whether or not China and Japan can revive their slowing economies. Right now, what happens overseas seems to provide the biggest risk for the U.S. economy and continued positive returns for the stock market.