Observing the Undertow in the Markets

By Zachary Valentine and Matthew Vera

Have you ever stood by a crashing ocean wave and contemplated the power of mother nature? Even more astounding is what cannot be seen under the beautiful current. The bright signs all around the beach warn of a strong undertow which can be detrimental or even deadly. Similarly, we are currently feeling the effects of bullish peaking waves in the stock market, and the force of the obvious bearish undertow in the bond market, retail, healthcare and energy sectors. What industries will the next wave hurt or help? Is it the housing market again, mortgage companies, airlines or something else?

According to Investopedia, a secular bear market is defined as “a market driven by forces that could be in place for many years, causing the price of a particular investment or asset class to rise or fall over a long period of time”. Alternatively, a secular bull market is when “strong investor sentiment drives prices higher, as there are more net buyers than sellers…in a secular bear market, weak sentiment causes selling pressure over an extended period of time”.

In a secular bull market, strong investor sentiment drives prices higher, as there is a fear of missing out on market opportunities, despite typical expanding economic indicators. In a secular bear market, weak sentiment causes selling pressure over an extended period of time. Luckily domestic equities have a shorter time frame than global markets outside of the United States. In a nutshell, low interest rates on mortgages and lines of credit are creating more disposable income for the average consumer. Yet, there has been little relief on tight credit and credit card rates. However, for the investor, low interest rates create such a low return rate on bonds and fixed income, that the investor is forced to look elsewhere to invest their money.

A current uncertainty in the market is energy. Crude has rotated down to shocking levels. Chevron, for example, recently traded down to eight year lows. Thirty years ago, West Texas Crude Oil traded at eight dollars a barrel, and a decade later it was trading at $149 a barrel. There are limited signs that would lead us to believe that the pressure on oil will be alleviated anytime soon.

All this is counter intuitive. With new money in the pocket of consumers—especially 18 to 30 year olds—as well as extra cash saved from the gas pump, discretionary funds are available for new phones, clothes, concert tickets etc., helping to stimulate the economy via the velocity of money.

Despite all this, the retail sector continues to face multiple breakdowns. Macy’s is closing 36 stores and laying off 2,500 employees. The Gap is in the process of closing 175 stores in North America. Wal-Mart is closing 269 stores with 154 of them located in the United States. J. C. Penney will be closing 47 additional stores, in addition to the 40 stores that were closed in 2015. The closing of these retail stores are just part of the story: even the largest cell phone company, Apple, down 34 percent at $99 a share.

What about restaurants, entertainment and movies? We see that disposable income from the average consumer is being spent in these areas. Shake Shack, for instance, remains more than double the price of its January IPO, but is down nearly 30 percent in the quarter. How many of you loaded up the family and headed to Disneyland this year for the 60-year anniversary? Disney is known to be one of the better bets in the market, but hasn’t been looking stellar lately. Even with the crowds at the parks, the stock is feeling the rotational pull for over a quarter. The latest Pixar hit “Frozen” grossed $1.3 billion at the box office, and perhaps as much in licensing merchandise. According to Forbes, Star Wars: The Force Awakens has globally earned nearly $1.9 billion, yet the stock has fallen from $122 to $97.

While many retail, energy and entertainment stock prices are rotating south in price, the markets are investing in consumer, financial, housing and airlines sectors which are moving full speed ahead. We believe this is the the undertow that will affect the markets. Airlines profits are soaring through the sky at 30,000 feet. How long can airlines believe that labor forces can go without a union strike, and how long will oil prices remain low?

American Airlines has benefited from crude declines due to the fact that they are the only airline that does not hedge its fuel. However, if they do not hedge and oil prices go up, the reverse undertow could greatly hurt profits. Airline research analyst Helane Becker of financial services firm Cowen Group writes, “American [Airlines] participates in 100 percent of the decline in jet fuel prices. The current per gallon price is $1.78, and American uses 4.4 billion gallons of jet fuel annually, so every $1 change in oil [saves the company] approximately $105 million per month”.

To add to the trend, homes are being purchased with five and ten percent down with partial borrowed down payments to ramp up to twenty percent to qualify for traditional bank financing for the remaining down payment. What does this remind us of?

Simply said, housing has doubled in many regions. What if housing follows the stock market? As noted in CNN Money, “lowdown payments make a comeback…the shift toward loans with lower down payments has drawn criticism from some politicians – after all, easy loans with little money down contributed to the crisis that led to the Great Recession”. Is there enough wage inflation and excess demand for labor to drive up wages and savings to continue this housing rally? Or is a temporary set back in price due like the stock market?

As an example, what if a new house is purchased at $1.3 million in San Ramon or Dublin, California with 10 percent down, plus 10 percent from a relative, plus 80 percent from the bank and the housing market demand reverses? Or the home owner has 20 percent ($260,000) and the bank owns 80 percent (or 1,040,000) of equity and the house value declines because of layoffs in the area or overbuilding? Well, oops, now we have an undertow and pardon the pun, called “underwater”.