Hartford Funds has published an analysis of “stock market returns after significant oil price declines.” They used the WTI crude oil price reference and examined a period of approximately 30 years ending in 2015. In their examination they found four events that were substantive. Independently, Jim Bianco published a similar analysis and brought the data current through January 20, 2016. We commend both firms on their excellent work.
The first event was the oil price drop that took place between October 1985 and March 1986. Hartford’s analysis indicated a price drop of approximately 66%. They then computed the S&P 500 Index total return one year after the price decline period ended. The result was a positive 37.66%.
The next period was September 1990 through February 1991. The oil price decline was 53% (57% if you use Bianco’s dating). According to Hartford’s computations, the subsequent S&P 500 Index total return one year after the price decline was complete was 15.99%.
The third event was December 1996 through November 1998. The oil price drop was 56%. Bianco uses a slightly different methodology and has the price drop at 61%. The S&P 500 Index total return one year after the price decline was 20.90%.
The last of the four events was June 2008 through January 2009. The oil price drop was 70% according to Hartford. Bianco gets 78% for that decline. Hartford computes that the S&P 500 Index total return one year after the price decline was 33.14%.
Key Question
In their research note, Hartford asks a serious question. What will happen after the current oil price decline runs its course? And, of course, what will be the price and total return of the S&P 500 Index one year after the price decline is complete?
According to Hartford’s calculation, during the period June 2014 through December 2015, the oil price drop was 65%. Jim Bianco data now shows 73% from peak to trough. In fact, depending on how you measure the oil price, the price decline this time could be the largest percentage drop in history. It may exceed the 70% decline that occurred in 2008 and 2009.
Will this oil price decline run its course? Yes, absolutely. At what price will it bottom? Not a single soul on the planet knows. What will happen after the bottom? History suggests that the transmission mechanism of low oil price to positive economic outcome, with rising consumption and other stimulative effects, takes about a year to unfold.
The historical data also suggests that once the positive rebound begins to unfold, it will become robust as a result of the $200 billion annual tax cut equivalent from the energy price fall. The 350 million of us who live in America and billions who live around the world have been receiving and will continue to receive this benefit.
After we rebalance our household balance sheets, raise our savings, and adjust our domestic budgets, we will start to spend this windfall. There are early signs that this process is underway. Subsequently, we will find ourselves with an extra $20 to $100 a week in our pockets. As we begin to realize the permanence of the excess, it becomes spendable. Economists call this the 'permanent income hypothesis'.
If you live in New York City, don’t own a car, and take the subway to work, the impact of the gasoline price drop is still there but is only indirectly observed and may seem insignificant. But if you live in Montana and drive 100 miles a day at high speed to get to work and back, the impact is huge and obvious. Therefore, the positive effects around the country depend on types of households and their location.
A drop in the oil price has immediate effects on credit, including high-yield and energy-related credit, and on regions of the country that are dependent on energy production, such as North Dakota and Texas. It is a negative force and quickly visible. We can already see it and measure its impact.
The oil price transmission mechanism that affects the entire nation and passes through the benefits of the price drop takes more time to operate and is more nuanced. We are starting to see those benefits now, and they are accelerating.
This analysis leads us to the following conclusions:
(1) We are not going to have a recession in the US. We are going through the negative phase of the energy price shock. The positive phase is still ahead of us; however, it has begun.
(2) The positive phase is likely to continue and become more robust. There is an accelerator function in the transmission from oil price decline to economic growth.
(3) There is no way to know how high the S&P 500 Index will go once the oil price downward shock is complete, nor can we time the upturn. There is a lot of history and supportive information to suggest that following the oil price shock, the US economy will be more robust. Our growth rate will pick up and do so from a platform that is fairly solid, because the economy will have run through the credit problems precipitated by the downward move in oil. Lastly, the rebound will be reflected in an upward movement in stock prices and higher total returns, with a strongly positive number from the S&P 500 Index.
Factoring in low global inflation and additional intervention by central banks worldwide, from the European Central Bank to the People’s Bank of China, we see the makings of an extended period – through the rest of the decade – with low single-digit interest rates, low inflation, ample liquidity, and a corrective mechanism that will express itself in rising asset prices as we go through this turmoil and come out the other side.
Furthermore, we remain optimistic about stock prices and committed to high-grade credits. We would not touch high-yield, and we won’t touch junk. We look for high-grade credits that will pay us during the turmoil. The cheapest high-grade credits around are still available in the tax-free municipal bond sector, where the yield on 30-year tax-free bonds is over 120% of the yield of the taxable US Treasury of the same maturity. That is a place of great opportunity if handled correctly in a portfolio management system.
When the oil price spikes down, the plunge creates turmoil. Then the oil price bottoms and the recovery creates massive opportunity.
We thank Hartford and Bianco Research for providing their data and analysis. At Cumberland, we are acting on the strategic approach outline above and have been doing so for some time. We will continue to extend and develop that approach in our portfolios.
David R. Kotok, Chairman and Chief Investment Officer.