Stocks and corporate bonds have continued to come under pressure.
Low oil prices have called into question global growth and the ability of banks to absorb losses that may arise from companies going bankrupt in the low oil price environment.
The Role Confidence Plays in Financial Markets
The weakness shows how important a role “confidence” plays in the financial markets. Without it, no one believes the validity of reported economic numbers, reported corporate profits, and bank bad loan reserves.
George Soros has put forth a market concept called Reflexivity, which essentially means that declining prices can by themselves cause a lack of confidence which, in turn, brings about even lower prices. This is what we saw in 2008-2009 when concerns over sub-prime mortgages caused bank stock prices to drop and the fall in prices brought out fears of failure and nationalization.
In 2015-2016, we have seen low oil prices cause concern about capital spending. Oil stocks and industrial stocks fell and this precipitated a doubt about the financial system, causing oil and bank stocks to fall even more.
Whether or not fears are well-found, it doesn’t matter in the short-run. If everyone believes in lower prices, lower prices will be the result.
How Regulators Have Destabilized Stocks
I would suggest that in our current market structure with index funds, it is very easy to sell. When one sells, they are selling the entire market or the entire sector without regard to the differences among companies. The good gets thrown out with the bad. Market moves seem to be quicker, and bigger than the moves that took place before the age of indexing.
Regulators have further destabilized stocks by removing the Specialist on the exchanges whose job it was to “keep an orderly market”.
Regulators also removed the “uptick rule” which said that a short trade could only be done after the previous trade was up.
Without these market controls, prices can drop quickly.
How to Turn Confidence Around?
So what will it take to turn confidence around?
Continued good economic news out of the US helps. January US Retail sales came in decent and December was revised higher.
The markets need some better news out of China. The transition of the Chinese economy from a manufacturing/export-based one to a consumer model has put pressure on emerging markets and global growth.
Given the turmoil in markets, the US Federal Reserve will be less likely to raise rates. Already, the Fed Funds Futures curve is predicting that the next Fed move will be a rate cut and not a raise. This has allowed the US dollar to weaken recently.
A lower dollar takes the pressure off emerging markets and helps US multinationals. The strong US dollar has been a major headwind for commodity, consumer, and industrial stocks.
The sentiment is very negative and it will take time for the market to find its footing. But rallies can come from nowhere, making it hard to be out of the market. Often, the biggest moves come at the start of a market recovery.
— Ian Green, Pendragon Capital Management
Subscribe to Pendragon's Newsletter
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.