February 24, 2016

While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment.  Today’s comment is from John Lisle.

The equity markets appear to be inexorably tied to the price of crude oil and the question of China’s economic growth or stagnation.  China will most likely remain a conundrum since accurate public information about the country’s economic performance is hard to come by.  The high correlation between the price of crude oil and the direction of the S&P 500 during the past several months has also been perplexing, but here there are some causal relationships.  For example, a drop in the price of crude oil is deflationary so this is apt to be a negative for banks’ earnings since their net interest margins vary with short term interest rates, which are apt to decline with deflation.  The severity of oil’s current price decline has been a major cause in the drop in capital spending contributing directly to the manufacturing recession (another drag on bank earnings) and the decline in revenues for the rails, trucking, and shipping.  So the price of crude oil can affect large swathes of our economy especially with a drop as dramatic as $106 to $28/barrel in a year and a half.

However, in the midst of the January selloff in the equity markets, the manufacturing sector stocks that have limited relationships to oil have climbed impressively beginning six weeks ago.  For example, Grainger# is up 24% in that time, 3M# up 17%, Illinois Tool# up 21%.   So these stocks are predicting continued economic growth and a recovery in the domestic manufacturing industry in spite of the Purchasing Managers’ Index being near a five year low.  In addition, commodities, which have been in surplus since last year, have bounced off their lows.  Iron ore is up 35% and oil up 27% off their low prices, for example.  Once again, a particular group of stocks, the worst performers over the past year, have indicated a distinct turn while the general equity market was in a swoon.  It’s looking like the pessimism around global growth has been overdone; a recession is unlikely this year.

Consumers, who are responsible for about 70% of GDP, have used savings from lower gasoline prices to shore up their balance sheets and may begin to spend more.  That wages are rising in many parts of the economy also contributes to consumers’ financial soundness and confidence.  For example, United Airlines maintenance workers are ready to strike after rejecting an offer of a 25% raise.  The UAW’s labor agreement increases starting pay from $17.50 to $29. Wal-Mart# and McDonald’s# have increased hourly pay, etc.  Higher wages will provide consumers with more ability to increase discretionary spending whether on a new car, a new bathroom, or a more desirable vacation.  Greater spending will increase company revenues, and that can drive Keynes’ animal spirits.  At this point, analysts are lowering S&P 500 earnings estimates for 2016. If higher wages drive increased revenues, these estimates are likely to reverse direction to the upside.

The S&P 500 has risen from an intraday low of 1810 on February 10th to an intraday high of 1945 two days ago.  That puts this average up 7.5% in two weeks and, once again, at the higher end of its average valuation range.  We’ll need to find out whether this optimism is well-founded in commodity price stabilization and actual revenue gains.  That will take some time.  In the meantime, we can expect volatility to continue.  And the most unpredictable presidential election in several generations won’t calm investors’ nerves as we approach November.  Stick with the fundamentals as we navigate the ups and downs of the daily developments.

The futures along with oil are down this morning.  The Saudis are not agreeing to oil production cuts proposed last week.

John Lisle, Jr. 610-260-2221

Additional information is available upon request.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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