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A Wall of Worry?
Toronto: June 16, 2014
By John Stephenson

North American stock markets are off and running again, with the S&P 500 returning 11.3% since its February lows.  As of Friday, the S&P 500 has gone 980 days without a 10% decline, the fifth-longest stretch on record.  The good news isn’t limited to stocks with interest rates falling by roughly 55 basis points so far this year, confounding both experts and bond bears.  An old saying on Wall Street is that “bull markets climb a wall of worry,” but this time around it seems as if bull markets are climbing a wall of complacency.

One measure of complacency is the VIX Index, or volatility index, which has been closing at post-recession lows as the stock market has been making new highs.  Tighter spreads, weak trading volumes as well as lower yields and volatility are a consequence of the weak economic recovery and heightened central bank vigilance. This lack of volatility has also expressed itself in narrow market breadth, suggesting the opportunity for active managers to differentiate between the strong and weak performers is just not as great. Despite the heady gains of the market, this low volatility world has made it difficult for active managers to outperform their benchmarks forcing them to increase portfolio risk-taking amongst their higher conviction names. 

While professional investors are fretting over the lack of alpha or outperformance opportunities, retail investors view the stock market’s rise with trepidation.  Retail investors are acting as if the market is perched on a knife’s edge.  A recent report by State Street Corp found that investors in sixteen countries around the world have raised their cash holdings to 40 percent from 31 percent over the last two years.

With a host of economic indicators suggesting that markets will move higher, not lower, it’s likely that the wall of complacency is likely to grow taller as markets continue their steady rise.  Supporting the case for a continuing bull market is increased small business optimism in the U.S., which now sits at its highest level since 2007.  Credit spreads have narrowed to their lowest level in ten years, while the three-month moving average of jobs numbers in the U.S. has moved soundly above the 200,000 per month level.  The Institute for Supply Management (ISM), one of the most important leading indicators that I track, has shown steady improvement over the last few months since tumbling in January.

While the lower volatility may be making it hard for professional investors to outperform their benchmarks, it is indicative of a continuing bull market for equities.  Generally, lower volatility is associated with higher stock prices with each seven percent decline in the VIX corresponding to a one percent gain in the S&P 500. 

Energy appears to be one area of the market where managers should be concentrating their bets, as the upheaval in Iraq could throw the world’s stable oil market out of balance.  Global oil markets have been unusually steady since 2010, but now with Islamic militants seizing two northern Iraqi cities and president Obama pondering military intervention, this delicate balance looks likely to be upended.
For now, the turmoil in Iraq is in the north of the country, away from important oil-producing regions in the south.  But the turmoil so far has caused oil prices to spike, with Brent crude, the key international benchmark rising 2.8 percent on Thursday, its biggest gain since August 2013.

OPEC the cartel that has dominated oil prices for much of the past fifty years has struggled to keep pace with global demand.  Libyan oil production has fallen by 90% in the last few months, while Iran, once the world’s second-largest exporter, has seen its exports slip in the face of Western sanctions by about one-fifth.  And production from Venezuela and Nigeria has slipped because of economic and political difficulties. The only real good news on the global supply front is U.S. shale oil production, which has risen by four million barrels a day over the past few years.

OPEC seems to be operating under the illusion that they still control the world’s oil markets. For decades their production quotas have been a joke with members routinely exceeding their monthly quotas.  And while OPEC just last week decided to leave their production quota at 30 million barrels per day, the actual production numbers for May are sobering.  Production managed to lag the official quota by three million barrels per day, suggesting that OPEC’s control over global oil markets may be slipping.

With supply struggling and geopolitical risks increasing, oil prices are likely to nudge higher in the weeks ahead.  But despite the sustained rise in oil prices, energy stocks, particularly those in Canada, look very attractive from a valuation perspective.  Low valuation, higher commodity prices and rising geopolitical risks are a recipe for investor profits in the months ahead.
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