Stock Market Correction Risk Increased

March 07, 2011

Will sharply higher oil derail global economic recovery?


Geopolitical Upheaval And $100 Oil Increase Stock Market Correction Risk

Upheaval in the Middle East/North Africa region has sent oil prices surging above $100 and caused the first significant U.S. stock market pullback since November. Thus far, the correction has been a modest 3% peak-to-trough, and this remains one of the longest running rallies in the S&P 500 without a 5% correction. That streak appears vulnerable, however, and this would certainly appear to be a time to patient about taking on additional risk in portfolios. In the event of a deeper correction, the first area of support for the S&P 500 comes in at 1275-1290, with major support at 1225-1240.


Exhibit 1



The situation in the Middle East and North Africa is obviously unpredictable. Markets can be expected to remain volatile and will react quickly to developments. No one can foresee how many countries will be engulfed by unrest and rebellion, or the degree to which the global oil supply will be threatened. The risk of sharply higher oil prices (e.g., $125 or higher)—which could derail the global economic recovery—is sufficiently elevated to warrant caution with respect to new long positions in the stock market. It is unsettling that the Saudi stock index has dropped 17% in past two weeks, given that Saudi Arabia holds 20% of the world’s oil.

Apart from the geopolitical backdrop, there are additional reasons to be cautious at this juncture

Ultra-Loose U.S. Monetary And Fiscal Policy Is Approaching An End

Unprecedented monetary and fiscal policies have created an economic recovery that is artificial to an indeterminate degree. Similarly, the massive rally in the stock market of the past two years has been built to an uncomfortably large extent on the shaky ground of extraordinary government intervention in the form of $1.5 trillion annual fiscal deficits and over $2 trillion of Federal Reserve asset purchase programs. Aside from job creation, which has been consistently disappointing, U.S. economic data have generally surprised on the upside over the past several months, but how the economy performs once stimulus begins to be withdrawn after the second quarter is an open question.

‘Quantitative Easing’ Set To End June 30


There has obviously been a strong correlation between the Federal Reserve’s quantitative easing programs and the performance of the financial markets. The 25% rally in the S&P 500 over the past six months commenced when Bernanke announced his intentions for a second round of market intervention through quantitative easing. The Fed has lubricated markets with $80 billion per month of Treasury bond purchases using newly printed money. This monetization program expires June 30, and in all likelihood will not be extended. Inflation pressures are simply too high for even Bernanke to justify continuing with such an unorthodox and overtly inflationary program (see Exhibits 2 and 3).



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