The Sideways Market

Why index funds have returned 0% over the last 18 months.

The current sideways situation (no gain or loss over several months) in financial markets began in late 2014, following a massive bull run (prices going up) during which US indices gained over 120% in 5 years. In surveying market analysis from multiple sources, two trends became immediately clear: most industry experts and professional money managers were extremely bearish (believe prices are headed down), while mainstream media was eager to believe the bull case(prices are headed up). The money managers seem to be following a logical thesis: the Federal Reserve will raise interest rates into an economic slowdown, leading to a market crash. Meanwhile, media and retail investors are counting on improved US growth to lead the next leg up in stocks. A year and a half after topping out, the markets have not moved significantly up or down. Each time the market corrects sharply down, it bounces back almost as quickly. Nearly all investors are chomping at the bit to know: are we in a bull or bear market? The answer is: Neither. Yet.

The current state of the markets is total uncertainty. There are clearly massive problems that need to be addressed before the US economy can continue growing. However, the cracks have not resulted in any large systemic problems yet. This financial purgatory has caused significant losses for well known hedge funds with impeccable track records. For example, Ray Dalio’s “All Weather Fund,” which is structured to make money in any market environment, lost 7% in 2015. Additionally, Kyle Bass’s Hayman Capital reportedly experienced a near 9% loss in 2015. A reason for these losses is that these hedge fund managers have succumbed to recency bias, something they tend to criticize retail investors for. In past market peaks and crashes, the top has been a sharp peak followed by a rapid decline. However, the 2014 market peak has looked more like a plateau with some potholes. On the whole, most money managers have failed to realize that this peak is very different from the previous two. The heavy influence that the Federal Reserve has had on the equities market has completely changed the way the market functions. The actions and projected actions of the Fedral Reserve have correlated very highly to market moves. In other words, when people think the Fed is going to raise rates, markets drop. When people think the Fed is going to lower rates or delay a rate hike, the market gets a boost. The chart below shows this quite clearly.

The US industrial production index decouples (stops moving in the same way) from the S&P 500 (a major US stock index) in late 2014. In early 2015, the first occurrence of bad economic news being good for stocks appears. Industrial production drops, but stocks continue to rise based on speculation that more quantitative easing (in other words, money printing) is on the way. In mid 2015, industrial data turns up, indicating a stronger economy with less need for federal reserve intervention. The market’s reaction: a 10% drop over the span of a few days. The process repeats itself in late 2015, showing that what investors think the federal reserve is going to do is critically important to market sentiment.

A piece of confounding evidence is the fact that the Fed has been able to raise the target interest rate by 0.25% while causing only a brief drop in equity prices. This leads into the next major driver of today’s markets: oil prices. As the chart below shows, after the Fed raised rates in December 2015, it resulted in a selloff in the S&P. However, oil prices bouncing up to nearly $50/barrel dragged the market up.

The bounce in oil prices caused the market to recover because debt-laden oil stocks had been dragging down the overall market. Higher oil prices opened the door for banks to make news loans to these companies on projections of $60 oil. Any new debt that has been issued to marginal oil producers during this oil price rebound will have 1st rights on whatever assets the oil companies own when they go bankrupt. In other words, the most recent lender gets 1st pick of anything of value a bankrupt company still has. Accordingly, every time a company takes on new debt, the old debt is subordinated to the new and the previous lenders lose their right to the collateral on which their loan was made. Eventually, the value of the old loans will have to be written down to reflect the reality that the debt is now more risky. This will result in banking/financial stocks dropping in price. After all, a bank only makes money if the loans it makes get repaid. If a financial sector drop coincides with a drop in oil prices, it will likely trigger the large selloff of equities that many experts have been expecting.

The sideways trade that the market has been exhibiting for the past few months could end in either a continuation to the bull market of the previous 5 years or a bear market, wiping out the gains of the previous run-up. The deciding factors will be the two forces that are currently weighing on the market: actions of the federal reserve and events in oil patch. Of the two factors, oil will likely be the more important in coming months. The billions of dollars of non performing loans lent to small, inefficient oil producers cannot be ignored. When the marginal oil producers start going bankrupt, banks will lose money on their loans. That money is gone. Forever. This will inevitably lead to a decline in broader equity prices. Simultaneously, Fed policy will be less important because central banker credibility has been in decline. The narrative that central bankers can ease the economy through the lows of the business cycle has been proven false and investors are realizing it.

The US equity market needs a major catalyst in order to make it move either up or down. It is likely that the catalyst will be major bankruptcies in the oil patch. Black swan events (low probability, high impact) have been major markers of previous bear markets in US equities. In 2008, the collapse of Lehman Brothers set off a major stock market crash. Lehman collapsed because they were highly exposed to non-performing housing loans. If an investment bank is too exposed to oil patch debt when companies start filing for bankruptcy, a similar scenario will undoubtedly play out. Tread carefully in the coming months.

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