Do Stocks Have a Favorable Risk-Reward?

A Saudi Arabian Oil Facility Was Attacked, the Repo Overnight Lending Market Froze and There Was Another Setback in Trade Negotiations with China – Yet the S&P 500 Was Flat for the Week.

This week started on a volatile note when a Saudi Arabian oil facility was attacked and 5.7 mm barrels a day output was knocked out, which is more than 50% of Saudi output and nearly 6% of the world’s oil supply. On Monday, the price of oil spiked by more than 15%, which was its largest increase since the 1991 Gulf War. While geopolitical and economic risk rose in the Middle East, the overnight lending market froze, and the Federal Reserve had to inject hundreds of billions of dollars to stabilize the market. On Friday, the Fed announced that they expect to inject approximately $75 billion each day into the overnight market for the next two weeks. 

Also, this week, as expected, the Fed reduced short-term interest rates to 1.75%, which was a reduction of 0.25%.  This was the Fed’s second rate cut this year, which rolled back half of the Fed’s four rate hikes from last year.  Finally, on Friday, the Chinese announced they would not visit farms in Montana. Investors believed this was another setback in trade negotiations and sold stocks. 

Despite increased economic and geopolitical uncertainty, the stock market remained calm. The S&P 500 decreased by 0.51%, while the tech-heavy Nasdaq 100 and the small-cap Russell 2000 fell by 0.88% and 1.16%, respectively, this week.  International stocks also pulled back, the MSCI EAFE Index (international ex-US and Canada) corrected by 0.36%%, and the MSCI Emerging Markets dropped by 1.49%.   

In this “risk-off” environment, the safe havens performed well — gold rallied by 1.0%, and the U.S. Treasury long-bond (TLT) jumped by 3.9% this week. After a 15% jump on Monday, the price of oil closed the week up only 5.9%. 

This week the markets received bad news, yet investors remained calm, and the stock market was relatively tranquil. While it appears that Iran’s attack on Saudi Arabia’s oil facility will not lead to an immediate military response by the U.S., and oil production should be fully online by the end of the month, the geopolitical risk in the Middle East has increased dramatically. Economic sanctions against Iran are crippling their economy, and they have turned to a strategy of brinksmanship by attacking energy asset in the Persian Gulf to negotiate relief.  

Although the oil market has stabilized, Iran’s intentions are unknowable, and it is probable that there will be more attacks on energy infrastructure in the Persian Gulf.  This year, the low price of oil (oil is down by 21% year-over-year) has helped our sluggish economy overcome the headwinds from the Fed’s 2016 through 2018 interest rate tightening cycle, the trade war with China, and the global economic slowdown.   

We believe that any sustainable increase in the price of oil above $65 would be a sizeable year-over-year spike in energy prices, which would negatively impact economic growth over the next six months and likely lead to the recession that the yield curve is forecasting (see chart).
In addition to the turmoil in the Middle East, investors had to contemplate the significance of the problems in the overnight lending market. The repo market (repurchase agreement market), which provides overnight funding to major financial firms froze for the first time since the “Great Recession.” Although the Fed stated the problems in the repo market are technical, and due to issues of liquidity and not solvency, it is unnerving that they had to inject more than $100 billion into the market this week and expects to provide $75 billion each day until October 10th

The Fed never saw this problem coming, yet by injecting massive amounts of money, they expect the issue to be resolved. It is disconcerting that the market froze in a period of little financial stress. What happens when the next crisis hits, or if the Fed is wrong and there is a solvency issue?  While we don’t fully know what is occurring in the repo market, we believe it is more evidence that this is a high-risk environment — i.e., we have a dollar liquidity shortage and an inverted yield curve.
Our View: The S&P 500 is within 1% of its all-time high, yet we are in a trade war with China, global growth is weak, and tension in the Middle East is elevated. In addition to an inverted yield curve — which has preceded every recession since WWII – the overnight lending market froze, and the Fed will inject hundreds of billions of dollars to stabilize it over the next three weeks

We believe that investors are complacent and overlooking significant risk because they think the trade war will end soon, and the Fed can lower rates to stimulate economic growth. In our view, the market offers a poor risk-reward – since stocks are expensive, there is little upside if everything goes right, but significant downside if a recession occurs. Historically, the S&P 500’s average decline during a recession is more than 30%, and stocks dropped by more than 50% during the last two recession. 

Instead of watching the stock market, which is near an all-time high, we believe that investors should focus on the bond market, which has a better track record of forecasting the economy. The 10-year U.S. Treasury yield has dropped by 1.25% (from 2.69% to 1.43%) this year, which led to the yield curve inverting in May.  This dramatic shift in interest rates indicates that bond investors are concerned that the Fed is too tight and economic growth is at risk.  Also, as expected, the Fed cut rates by 0.25% this week. Unfortunately, the market didn’t think it was enough – the dollar rallied, and the 10-year U.S. Treasury yield fell by 6bps.
Our Tactical Allocation (six-month view) is negative.  After a three week rally, the S&P 500 dropped by 0.51% this week. We continue to believe that investors are too optimistic, market breadth is weak, and stocks are in a period of negative seasonality.  Despite two rate cuts from the Fed and new QE from the ECB, stocks are down slightly since the Fed’s July 31st initial rate cut. Central bank stimulus and scheduled trade talks with China have not been able to drive stocks higher.  We believe that the market is priced for perfection, and poised for a correction. We will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve.

Our Strategic Allocation (six-year view) remains underweight equities, overweight bond duration, and gold. We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated.  Also, we believe that the market is too complacent regarding the problems in the Middle East. In our view, any sustainable spike in energy prices would lead to a recession. At the sector level, we remain overweight the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.
  • lmanley
  • September 23, 2019

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.

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