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Does The S&P Really Need Higher Oil?

The steady drumbeat of lower and lower Crude Oil prices continues. With the S&P 500 struggling to hit new highs in 2015, much of the blame has been placed on lower Oil prices. Do stocks really need higher Oil to perform well? The steady drumbeat of lower and lower Crude Oil prices continues. Oil’s fall from its peak in 2014 is up to an astounding 67%. This is fast approaching the largest decline in history, the 68% drop during the financial crisis of 2008-09. (click to enlarge) With the S&P 500 struggling to hit new highs in 2015, much of the blame has been placed on lower Oil prices. If only Oil prices were higher, say the pundits, stocks would be soaring. But how accurate is this story? Do stocks really need higher Oil to perform well? Let’s take a look back at history. We have data on Crude Oil (Generic First Futures via Bloomberg) going back to March 1983. The monthly correlation to the S&P 500 since then? Essentially zero (.05). Looking at the rolling 1-year correlation, we can see there are times where Oil and equities are positively correlated and other times when they are negatively correlated. (click to enlarge) During the financial crisis of 2008 and its aftermath, the correlation between equities and Crude became more consistently positive and higher than in prior cycles. Why? A deflationary, depression-like collapse was the major fear in 2008, and lower Crude prices that year were said to be a harbinger of bad things to come. When that theory did not materialize in 2009, the opposite was said to be true. The rally in Crude was thought to be a positive, indicating reflation and stronger global growth. This relationship would persist until 2014 when Crude began its most recent collapse. Since then, while equities have struggled to hit new highs, there has been little overall correlation with Oil. This is more in line with history, as evidenced by the table below displaying calendar year returns in Crude Oil and the S&P. Some thoughts on their unpredictable relationship: From 1984-87, Crude declined every year while the S&P advanced. The S&P continued to advance in 1988 and 1989 while Crude rebounded. Then, in 1990, the S&P experienced its only down year in the 1982-99 period while Crude Oil was up 30%. From 1994-96 the S&P and Crude moved up together. From 1997-98, Crude declined while the S&P experienced two strong years. The 2000-02 Bear Market in stocks displayed no obvious correlation to Crude. From 2003-07, Crude and the S&P rose together during the commodities boom. In the 2008 deflationary collapse, they declined together and during the 2009-11 reflation they rose together. In the past two years, as Crude has suffered one of its worst declines in history, the S&P is higher. So do U.S. stocks really need higher Oil prices to generate a positive return? The answer based on the historical evidence is clearly no. Why? Because it is not clear exactly what a higher or low Crude price means for the overall economy and an S&P 500 Index where the Energy sector which comprises less than 10%. Most studies show that the U.S. economy (and U.S. consumer), as a net consumer of commodities, ultimately benefits from lower Oil and Gas prices. Similarly, companies outside of the Energy spectrum benefit from lower input costs. Ultimately, the correlation between Crude and stocks depends on why Crude is moving higher and lower, which is difficult to ascertain in the moment. It only becomes clear in hindsight. Certainly a crash in Crude as we saw in 2008 which was an indication of a collapse in global demand was not going to be a positive for the U.S. equity market. However, a crash in Crude due to increasing supply and alternative forms of Energy could very well be construed as positive for markets. Is that the case today? Again, we’ll only know in hindsight. Ironically, while the fear of the day is over lower Crude Oil prices, historically the opposite situation has been more harmful for markets and the economy. If we look back at history, 1-year spikes in Crude above 90% occurred in 1987, 1990, 2000, and 2008. All of these spikes were associated with equity Bear Markets and the 1990, 2000, and 2008 spikes associated with U.S. recessions. So perhaps the greater fear should be not a continued slide in Crude but a spike higher. (click to enlarge) That is not to say that some stability or a bounce in Crude in 2016 would not be welcomed by U.S. stocks. It most likely would if the rise could be attributed to an increase in global demand. But predicting whether and why Crude rises and falls is not an easy game to play. Harder still is predicting its impact on stocks. This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. CHARLIE BILELLO, CMT Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mitial funds nd separate accounts. He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms. Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant certificate.

JPMorgan Adds To Suite Of Diversified Return ETFs

JPMorgan’s Diversified Return ETFs are strategic beta funds that seek to improve the risk-adjusted returns of diversified portfolios. Each is based on a FTSE Diversified Factor index designed to exclude expensive and low-quality stocks with weak momentum characteristics. JPMorgan’s first Diversified Factor ETFs began trading in June 2014. By December 2015, the suite had grown to include the following funds: Diversified Return Global Equity (NYSEARCA: JPGE ) Diversified Return International Equity (NYSEARCA: JPIN ) Diversified Return Emerging Markets Equity (NYSEARCA: JPEM ) Diversified Return US Equity (NYSEARCA: JPUS ) Core European Exposure The fifth member of the lineup, the JPMorgan Diversified Return Europe Equity ETF (NYSEARCA: JPEU ), began trading on December 21. The ETF is designed to serve a foundational role in a developed Europe stock portfolio by combining portfolio construction with stock selection in attempting to produce higher returns with lower volatility than traditional market cap-weighted indices. “The European recovery provides a growth opportunity for long-term investors,” said Robert Deutsch, J.P. Morgan Asset Management’s Global Head of ETFs, in a recent statement. “JPEU is constructed to allow investors to participate in the upside while also providing less volatility in down markets” Like all JPMorgan Diversified Return ETFs, JPEU tracks a FTSE Diversified Factor Index – in this case, the FTSE Developed Europe Diversified Factor Index. The index was “thoughtfully constructed” based on JPMorgan’s “active insights and risk management expertise,” according to the statement, and is rebalanced quarterly. “We are excited to partner with J.P. Morgan ETFs and together meet the growing demand among investors for a broader set of international options, by offering the FTSE Developed Europe Diversified Factor Index,” said Ron Bundy, CEO of North America benchmarks for FTSE Russell. “We continue to apply FTSE Russell’s expertise in global strategic beta indices to expand on this very important long-term relationship.” European Equity Experience JPMorgan’s James Ford and Richard Morillot, both vice-presidents, are the co-managers of the fund. JPMorgan has been investing in European markets since 1964 and manages $37 billion in European equities. “We are pleased to combine the investment expertise of J.P. Morgan with the index design capabilities of FTSE Russell, to create a product that will be attractive to investors looking for exposure to European markets, but are concerned with volatility,” said Mr. Deutsch.

Do Historical Comparisons Matter? Strong Similarities Between 1937 And 2015

The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. Market participants might want to consider a similar period in history – a time when the 10-year Treasury offered paltry yields, GDP grew at a reasonable clip and the Fed tightened monetary policy. The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. However, market participants might want to consider a similar period in history – a time span when the 10-year Treasury offered paltry yields, gross domestic product (GDP) grew at a reasonable clip and the Federal Reserve tightened monetary policy. In late 1936, GDP had been growing steadily and the 10-year yield averaged 2.6%. The Fed chose to modestly compress the money supply after years of extraordinary stimulus. Indeed, the 1929-1932 “Great Depression” seemed as though it had been been vanquished. Unfortunately, by the second quarter of 1937, investors became alerted to signs of economic deceleration. Risky assets began to falter. The Fed quickly reversed course from tightening to easing, even engaging in market-based asset purchases. To no avail. An insipid recession occurred in spite of the central bank’s rapid policy reversal. Before all was said or done – by the time the 1937-1938 bear had finally ended – stocks had already plummeted 51.5%. Here in 2015, we have experienced steady economic growth for six-plus years with GDP expanding at approximately 2.2% per year. It has been an anemic recovery, but an expansion nonetheless. ( Indications of economic deceleration abound .) Meanwhile, the U.S. stock bull has been remarkably robust, both in duration and magnitude. One researcher estimates that the current bull market period has been more powerful (since 3/09) than 90% of the preceding rallies since 1900. (See chart below.) Similar to the circumstances in late 1936, when the economy appeared relatively healthy, stocks performed admirably, and the Fed started to tighten monetary policy after a long hiatus, the 2015 Fed recently embarked on its first overnight lending rate hike. Those who ignore the similarities say that it is only 25 basis points; they believe that members of today’s Federal Reserve are smarter than their predecessors and that they would not endeavor to normalize borrowing costs unless the economy were strong enough to withstand the shift. Me? I am skeptical. Here are three additional similarities between 1937 and right this moment: 1. The Last Time Stocks, Bonds, And Cash Did Not Work . Asset allocation is not working . Granted, the iShares S&P 500 (NYSEARCA: IVV ) is up 3% through December 2009, with 1% coming on today’s (12/29) price jump and the rest of it coming from dividends. Yet the iShares Mid-Cap ETF (NYSEARCA: IJH ) that tracks mid-sized corporations in the S&P 400 logged -0.5% through 12/29 and the iShares Russell 2000 (NYSEARCA: IWM ) that tracks small-cap stocks registered -2.3% through 12/29. The more that one diversifies, the worse things get. Add foreign stocks via iShares All-World excluding U.S (NASDAQ: ACWX ) for -4.0%. Inject iShares High Yield Corporate Bond (NYSEARCA: HYG ) for -5.2%. Dare to emerge with Vanguard FTSE Emerging Markets (NYSEARCA: VWO ) for -14.7%. In fact, Bloomberg tracked 35 ETFs that invest in different asset types to uncover a median loss (-5.0%). Even the all-in-one solution via iShares Core Growth Allocation (NYSEARCA: AOR ), which offers 60% in stocks and 40% in bonds, served up a negative result (-0.7%). According to research compiled by Bianco Research LLC in conjunction with Bloomberg, you have to go back to 1937 to find a 12-month run where asset allocation performed as poorly. Coincidence? Could be. Or perhaps investors in 1937 struggled with the same concerns about a return OF capital as opposed to a return ON capital. 2. Overvaluation Then, Overvaluation Now . Nobel laureate in economics, James Tobin, proposed that the combined market value of all companies listed on the exchanges should be roughly equal to their replacement costs. He then developed the “Q Ratio,” which divides the total price of U.S. stocks by those replacement costs of corporate assets. Tobin’s Q hit 1.1 earlier this year, suggesting that stocks traded 10% above the value of companies’ assets. Not so bad? That reading has only been surpassed by the year 2000. Moreover, if one assumes the year 2000 was a moment of ridiculous dot-com euphoria, you’d have to go back to 1937 to find a reading that suggests similar overvaluation. Keep in mind, this ratio has only surpassed the 1.0 threshold on one-tenth of trading sessions, most of which occurred in the late 1990s. The average (mean) Q ratio is approximately 0.68. 3. “Spread Spike” For High Yield Bonds . Back in May of 1937, the high-yield bond spread rocketed 85 basis points. Here in 2015? We have two occasions where high-yield bond spreads have spiked by more than 1%. Normal market fluctuations? Hardly. When investors abandon the credit markets, they are concerned about a wave of corporate defaults. And they’re not just worried about energy defaults either. High yield corporate credit is struggling clear across all sectors of the economy. (See Bloomberg chart below.) Are the circumstances in 2015 identical to those in 1937? Of course not. Every well-read market participant recognizes that history has a habit of rhyming, not repeating. Nevertheless, keeping a higher allocation to cash than you might otherwise keep is sensible in this late-stage stock bull. Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.