The equity markets suffered the worst weekly decline in three years last week. The basis for the drop in stock prices was the growing belief that plunging oil prices are a harbinger of economic trouble. The concern is that a recession and deflation in Europe could spread to our shores.

Stocks entered the month with high expectations. December, historically, is one of the strongest months for stocks of the year. The good news is that last week’s soaring volatility has squeezed out much of the investor optimism found earlier in the month. The CBOE Volatility Index nearly doubled last week, indicating that fear has entered the stock market. In addition, the demand for put options exploded, triggering short-term buy signals (puts are bought in anticipation of a decline in stock prices).

Using contrary opinion, the probability of a year-end rally remains high. Most of the gains in the final month typically occur late in the month with rallies often beginning just before Christmas. The risk in the stock market the remaining 13 trading days of December is believed to be 1960 using the S&P 500 with the reward to 2070.   

The Federal Reserve Open Policy Committee meets next week. Best assumptions are that the Fed will point to improving economic conditions which will allow for the removal of the “considerable time” reference as to when the Fed’s first rate hike could occur. We continue to believe that the Fed will maintain the zero-percent interest rate policy in 2015.  Inflation is a global phenomenon. Europe and Japan continue to experience strong deflationary pressures.

The Producer Price Index for final demand fell 0.2% in November, the third decline in the past four months. This indicates that the stronger U.S. dollar and falling energy prices are applying downward pressures on consumer price inflation. Considering that real wages have not improved in more than six years, the Fed is unlikely to move away from current monetary policy until such time that wage growth approaches 4.0% (currently at 2.0%).  Absent of rapidly rising wages, a dovish Janet Yellen is very unlikely to increase interest rates in 2015. 

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate. 

Evan R. Guido

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