The Next Correction

Over the last few months we have seen a fairly dramatic decoupling between oil prices and stock prices.  The chart below shows that prior to this year, there had been a fairly strong correlation between the two.  This correlation broke down early in 2017 when the price of oil inflected lower even as stock prices continued their long ascent.  As it now stands, oil has dropped over 20% so far this year – a drop that meets the technical definition of a bear market.  Quite the opposite, the S&P 500 is up over 9% for the year and hasn’t even sustained a correction (10%+ drop) in over 16 months.

The last time we saw a drop in oil of this magnitude was late 2015 to early 2016.  During that sell-off, the major stock indices suffered losses as well.  In fact, the spillover effect from the energy collapse was enough to drag the S&P 500 into correction territory.  Since that correction, the S&P 500 has rocketed to all-time highs with only minor setbacks along the way.  From an historical perspective, this market rally is long-in-the-tooth.  But it doesn’t appear that weak oil prices will be enough to trigger the next correction or bear market.  Some other factor will be to blame.  History doesn’t repeat itself, but it often rhymes.

*Source: Bloomberg and Standard & Poor’s

So why hasn’t the precipitous drop in oil caused a correction in stock prices this time around, and what could be the trigger for the next market correction (which WILL come)?   Well the first reason for the market’s resilience of late is that the Energy sector is far less influential than it has been in years past.  The sector’s current weighting in the S&P 500 is less than 6%, which is less than half of the level in 2011.  Another reason is that the weakness in the Energy sector (S&P 500 Energy sector down 14% so far this year) is being offset by strength in two far more influential sectors: Technology (+19%) and Health Care (+16%).  As we have covered in previous Market Commentaries, the strong performance for the Technology sector is being driven by a small number of mega-cap names that have done exceedingly well this year (Amazon, Apple, Alphabet, Facebook, and Microsoft).  A stumble by these few heavyweights could clearly be the source of the next correction.

*Source: Bloomberg and Standard & Poor’s

But there could be other triggers for the next correction as well.  The recent strength in the S&P Health Care sector is somewhat surprising given the highly uncertain fate of pending health care legislation.  The latest news is that a revised version of the Senate bill could be released as early as Friday, with a vote following the July 4th holiday.  Our read on both versions (Senate and House) is that the new legislation could be positive for health care companies in several ways: 1) Pharmaceutical companies, insurance companies, and medical device companies would stand to benefit from the reduction or elimination of taxes that were imposed on them to help pay for the expansion of insurance coverage under the ACA; 2) Though the possible elimination of the insurance mandate (everyone must buy insurance or pay a penalty) would seem to be a negative for insurance companies, the reality has been that many younger and healthier folks have chosen to just pay the penalty rather than buy the insurance.  The resulting adverse selection has led many insurance companies to exit healthcare exchanges altogether in certain states; 3) Insurance companies might be permitted, under the new laws, to provide less generous benefits in their plans rather than ACA-mandated benefits; 4) Insurance companies might benefit from extra federal dollars used to stabilize the insurance markets; 5) A big portion of the proposed Medicaid cuts could happen several years down the road, which reduces the near-term impact and allows for the possibility of a reversal of the cuts prior to the time the cuts take effect.

But there are also some clear negatives for some health care companies: 1) Fewer insured people should mean less demand for health care products and services overall.  This would likely impact drug companies, device companies, insurance companies, hospitals, etc.; 2) Hospitals, especially those that see a lot of Medicaid patients, could be especially hard hit by the proposed Medicaid cuts through the treatment of more uninsured people who don’t have the ability to pay; and 3) Insurance companies that cover a lot of Medicaid patients could be especially hard hit.

And then there’s the possibility that the Republican Congress and Trump administration are unable to get enough votes to pass major health care reform.  What then?  Will Congress simply give up, maintain the ACA in its current form, and move swiftly to enact sweeping tax reform?  Is it any more likely that Congress will agree to major changes in the tax code?  Oh, and by the way, next year is 2018 and there will be mid-term elections.  Will the Republicans maintain their majority in the House?

Landmines are everywhere, in plain sight as well as hidden.  Stay invested but defensive.