Why are Markets Climbing the Wall of Worry?

Markets act in a weird manner! Computers and algorithms do not cause
markets to act the way they do. Markets act the way they do because they are
reflecting what people are doing with the money they manage.

A decline in any market produces the fear of sustaining a loss. Some react to
this fear by selling, which can cause prices to fall even more. Since we think that
what has happened in the past will continue, pessimism builds. At a certain point,
when all who want to sell have sold, prices do not go down anymore, even though
there is still a lot of pessimism. There are always some disciplined bargain hunters
who want to take advantage of low prices so this buying enables prices to rise
again while pessimism remains. Markets can climb for months in the face of all
sorts of obstacles. We witnessed this when stock prices climbed to record highs
later on in 2020 even after the global economy was shut down due to Covid-19.
Numerous recoveries in the face of bad news over the last century has produced
the saying that “Markets climb a wall of worry.” You have just witnessed another
example of this in the last two months.

Two months ago, it seemed like interest rates were going to rise much more.
Now it looks like bond yields may have peaked, even though the Fed may raise
interest rates once more later on in September.

The invasion of the Ukraine caused commodity prices to rise sharply in the
spring. Commodity prices have rolled over since then. Directly or indirectly, oil
prices impact almost everyone in the world. This is why oil prices are such a
major factor in the economy.

Oil prices had a peak of US$122 on June 8, 2022 and fell to $88.11 a barrel
yesterday. Oil prices were in the low US$80 range last October when the average
gasoline price in the US was $3.34 per gallon. Oil prices are not far away from the
low $80 level now. The average US gas price peaked at $5.03 in June of this year
and is back down to $3.86 per gallon as of August 15th. It is getting closer to the
$3.34 level of last October. (Please see the chart below from WSJ.)

What should oil prices do in the future? There are clear advantages to writing a
book and these weekly Investment Updates because you and I can go back to check
on what was forecast and what actually happened after. (I have a record of all 750+
of them.) This is the headline of the December 9, 2014 Investment Update.

 

On December 9, 2014, I based the forecasts for oil entirely on how oil prices
traded during the previous consolidation phase from 1980 to 2000. Please see the
forecasts below.

From page 3
“There is no telling where oil prices will bottom. They will find a low when the
supply meets the demand. However, we can look back at history to see what has
happened in the past. If oil prices were to fall as much this cycle as they did in the
previous cycle, a 74% fall from $147 would take prices down to US$38 a barrel.
(The price today was US$63.)”

From page 4,
“Oil prices first fell to the low price for the cycle five years after the peak in
1986. It has now been six years since oil prices peaked at $147. Oil prices are
collapsing now, just like they did out of the blue in 1986. If markets follow the
pattern of the 1980’s and 1990’s, prices could reach a low soon, and then trade in a
$40 to $80 range for the next 13 years or so before falling to the second and final
low.

Please see a long-term chart of oil prices below.

You can be the judge for how accurate previous cycles have been for
predicting the trend of oil prices in the future. My forecast on December 9, 2014,
was for oil prices to fall to $38 a barrel. You can see that they bottomed in
January 2016 at $33.62. The high was $74.15 in June 2018.

After Covid, oil prices reached a low of $16.94 on April 19, 2020, and a peak
of $120 on June 5, 2022. Oil trades at $90 today.

You can see that oil prices have indeed traded in the $40 to $80 range for
almost all of the period from December 2014 until the end of 2021. Oil prices
have traded above $80 for most of 2022 but this is likely to be temporary.

There was a time in the previous consolidation phase when oil prices spiked to
record highs in 1990, after Iraq invaded Kuwait. Prices retreated again soon after
that. Therefore, what has happened to oil prices this year is not something new
for a consolidation cycle. Every person who wants to determine the direction of
oil prices in the future has a choice of using the record of what has happened in
the past or some other means of analysis. If you choose to look at history, it
suggests that oil prices should decline into the $40 to $80 range again and then
remain within that range for the most part for years into the future. At this time,
the trend is intact.

Since oil and gasoline prices are an important component of inflation, the
trend of oil and gas prices is cooling inflation.

While many are expecting a recession, the statistics coming out are showing
few signs of one. Therefore, if there is a recession, it could be a very mild one.
We must remember that we may not get the official word that the US economy
has entered or ended a recession until a year or so after the fact. Corporate
earnings are also coming in at encouraging levels. Many of the professional and
individual investors who sold as stocks were falling in the first half of the year
realized that they were under invested in stocks as conditions started to improve
instead of getting worse. Stock prices have once again climbed the wall of worry
since June as conditions have been better than expected.

The next meeting when the Fed might adjust interest rates is on September 20th
and 21st. The spread between the three-month US T Bill and US 10-year bond fell
as low as 0.07% this week and is at 0.21% today. (See the chart below from
YCharts.)

If oil prices and inflation continues to decline in the next month, the Fed may
have a reason to restrain themselves from raising interest rates much more. This
could be the catalyst investors are waiting for as a sort of all clear sign to become
fully invested again. It is very likely that another increase in US interest rates by
the Fed would cause this yield spread to invert. In a month from now, we will see
what the priorities of the Fed really are. They have to find a delicate balance
between fighting inflation, staying out of a recession and keeping interest rates as
steady as possible. In the meantime, stock markets seem to be climbing the
proverbial wall of worry.

When most people go fishing, they measure the fish they catch in inches or
pounds. In Chilliwack, we measure them in feet. These men allowed me to watch
them reel in a sturgeon on the Harrison River that was more than 5 feet long. The
sturgeon are released after they are caught since they are endangered. They are an
amazing creature! Stay safe and have a good weekend my friend!