Monday, May 2, 2016

Will an oil spike kill the stock bull?

I recently wrote about my scenario for a market top in 2016 (see My roadmap for 2016 and beyond), which goes something like this:
  1. Unemployment is now at 5.0%, which is a point at which the economy historically started to experience cost-push inflation.
  2. Inflation edges up, which is already being seen in commodity prices.
  3. Initially, the Fed is content to let inflation run a little "hot" because of what it perceives to be slack in the labor market, but as inflation and inflationary expectations tick up...
  4. The Fed finds that it is behind the curve and responds with a series of rapid rate hikes.
  5. The economy slows and goes into recession.
  6. Stock prices fall as the probability of a recession spikes and a bear market begins.
The biggest variable is timing. I believe that we are roughly at phase 2 of this process. Despite the possibility of a market top on the horizon, it is too early for investors to get overly defensive right now. There is still money to be made as growth expectations ramp up (see How the SP 500 could get to 2400 this year).

Then I came upon a note from a reader, who used a rule-of-thumb of an 80% run-up in oil prices as a precursor signal to a recession and bear market. 80%??? Crude oil bottomed in February at about $27 and we are nearly there! (He later amended that comment to an 80% year-over-year change in oil prices.)

The discussion led me to the work of James Hamilton, who showed that oil shocks have tended to precede economic recessions. If that is indeed the case, then how far is the American economy from a recession now that oil prices have spiked?

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