Tuesday, December 16, 2014

Walls of worry update

The equity market is now in the midst of what looks like another wall of worry. The last wall of worry was all about Ebola, while this time around the market is worried about the collapse in the price of oil—down almost 50% since last June—and how that is affecting major oil producers, notably Russia, whose currency has lost about 50% of its value over the same period. This all amounts to a tremendous amount of change in a relatively short period, and that's enough to make anyone nervous. 

As the chart above shows, the ratio of the Vix index to the 10-yr Treasury yield (a proxy for fear and uncertainty) has spiked almost as much as it did during the height of the Ebola panic. The equity market hasn't sold off quite as much yet, however, but it's not hard to imagine that the oil panic and surrounding uncertainty will take some time to digest. 

Oil prices won't stop falling until producers cut back and/or consumers boost their oil consumption. That won't happen instantly, unfortunately. But there is little reason to think that prices are going to go down a black hole, and there's little reason to think that the world's oil consumers are going to decide to consume less now that oil is so much cheaper. It's easy for producers to halt new exploration, and it would seem that a halving of the price of oil ought to make a lot of wells unprofitable enough for their owners to shut down production, at least enough to chip away at the current oil glut. 

I note that the world survived an even greater oil supply shock in 1986, when the price of crude fell from $29/bbl in early 1986 to $8/bbl by mid-1986. It then bounced back to $18 by the end of the year. Nevertheless, that was a collapse of over 70% in a six-month period, and the world didn't end. GDP growth slowed briefly to 2.1% in the second quarter of 1986, but went on to post 3% growth for the year. I also note that the U.S. economy today is far less dependent on oil than it was in 1986. Oil consumption per unit of output has declined by over 40% since 1986, in fact.

UPDATE: For comparison purposes, here's an updated version of the "walls of worry" chart, as of the close of the market 12/17:

The inverse relationship between the market's fears and the price of stocks is remarkable. Fears peaked yesterday and subsided substantially today, mostly after the release of the FOMC minutes which revealed that the Fed has not changed its policy intentions. In addition, oil prices and the ruble bounced, both suggesting that yesterday's panic was overdone. Result: stocks rose 2%.

UPDATE1: As of the close of the market 12/18: the market now thinks that the big decline in oil prices is perhaps not so bad after all. Plus, the FOMC is behaving predictably, so uncertainty has subsided. Result? Another drop in the Vix/10-yr ratio, and a surge in stock prices:

I find this fascinating.

UPDATE2: As of the close 12/22, the level of fear is down further (though till elevated) and the S&P 500 is at a new all-time high.


Benjamin Cole said...

Jitters galore. It does not help that the European Central Bank is practicing monetary asphyxiation on the continent, and Putin is the picture of an injured and stupid bear.
Still, net net as they like to say, lower oil prices should be good for the world economy.

Michael McGaughy / 麥德安 said...

Nice insight. I enjoy your market knowledge and link to what happened in the past.

David Landy said...

This metric shows that the ratio of bulls to bears is very high. It contradicts in some sense, the "wall of worry" idea.


Scott Grannis said...

David: The bull/bear readings that are so popular only represent a sampling of investor sentiment. I don't pay much attention to them, since I'm more interested in what ALL investors think. I think I can determine overall sentiment by looking at key market indicators (e.g., implied inflation, PE ratios, credit spreads, implied volatility, interest rates) since they are determined by the interplay of all investors from all markets.