Unexpectedly Intriguing!
January 15, 2015

Via e-mail, one of our readers asked some very good questions, which frame the seemingly fortunate economic situation in the U.S. pretty well:

With the falling price of oil, there is a chance to see if “trickle up” economics work as opposed to "trickle down" economics … What is the overall economic impact of lower fuel prices?

It seems the lower price of oil may be with us long enough to test the “trickle up” theory. I use the term "trickle up" because this is not the result of government Keynesian policies that narrowly focus the economic shift. Everyone, rich and poor, is being given a choice on how to reallocate their money now that fuel costs are a lower percentage of their expenses. [ assuming the government doesn’t find a way to take the extra $ back with new taxes ]

Many assume that if Wall Street is taking a hit due to the impact of low oil prices, the country is taking a hit … perhaps the stock market is only a short term indicator of national economic health at the top of the economic chain. If this is the case, stock prices only provide a short term “trickle down” view of the state of the US economy. What if “trickle up” is a longer term economic phenomenon that works outside the cycle time of the market? What indicators show the impact of extra money in every individuals pocket? Are there any short term “trickle up” indicators?

Here is the response we provided back on 5 January 2015, which we've modified since by either expanding our comments to quote things we had only linked before, or [making some correction in grammar or spelling], or adding links to news articles that hadn't yet been written:

[We] think the key to determining if there is such a trickle-up effect is to recognize that there are different cycles at work, which aren't necessarily synchronized with each other. For instance, if they were, then Lance Roberts' take on the economic impact of falling oil prices would be correct:

In the financial markets and economics it is a common occurrence that the media and commentators will latch on to a statement that supports a cognitive bias and then repeat that statement until it is a universally accepted truth.

When such a statement becomes universally accepted and unquestioned, well, that is when I begin to question it.

One of those statements has been in regards to plunging oil prices. The majority of analysts and economists have been ratcheting up expectations for the economy and the markets on the back of lower energy costs. The argument is that lower oil prices lead to lower gasoline prices that give consumers more money to spend. The argument seems to be entirely logical since we know that roughly 80% of households in America effectively live paycheck-to-paycheck meaning they will spend, rather than save, any extra disposable income.


The problem is that the economy is a ZERO-SUM game and gasoline prices are an excellent example of the mainstream fallacy of lower oil prices.


The obvious ramification of the plunge in oil prices is that eventually the loss of revenue will lead to cuts in production, declines in capital expenditure plans (which comprises almost 1/4th of all capex expenditures in the S&P 500), freezes and/or reductions in employment, and declines in revenue and profitability.

The majority of the jobs "created" since the financial crisis have been lower wage paying jobs in retail, healthcare and other service sectors of the economy. Conversely, the jobs created within the energy space are some of the highest wage paying opportunities available in engineering, technology, accounting, legal, etc. In fact, each job created in energy related areas has had a "ripple effect" of creating 2.8 jobs elsewhere in the economy from piping to coatings, trucking and transportation, restaurants and retail.

Simply put, lower oil and gasoline prices may have a bigger detraction on the economy that the "savings" provided to consumers.

Newton's third law of motion states:

"For every action there is an equal and opposite reaction."

In any economy, nothing works in isolation. For every dollar increase that occurs in one part of the economy, there is a dollars' worth of reduction somewhere else."

But the thing is that there is extra money coming into the economy because significant income (jobs) has/is not yet being lost in the oil industry. That "extra" money has provided a small, stimulative burst where increased economic activity in other sectors [of the economy] (such as restaurants, to name one industry that immediately benefited from the oil price decline in 2014), produce more income (growth) through a "trickle-up" effect, which is a big reason why the U.S. economy did so well in 2014-Q3 and Q4.

Perhaps the biggest question going into 2015 is how long that dynamic can play out. We would anticipate that the stock market will be especially rocky as oil industry-related companies begin to cull their dividends in greater numbers, which will be offset to the degree that firms in other industries might boost theirs. There are other dynamics that play into that, but from the core fundamentals that drive stock prices, that's the main aspect to which we're paying close attention at this time.

Water Trickling from Faucet - Source: ready.gov

Today, we're finding out that dynamic is just about played out, which we're seeing investors recognize through falling stock prices, falling yields for long term U.S. Treasuries, and falling commodity prices.

Worse, the fourth quarter of 2014 is turning out to not have been anywhere near as good as expected. Retail sales plunged in December, while the falling oil prices promise to dent economic activity in the states that have led the U.S. economic recovery following the December 2007-June 2009 recession.

That trickle up effect was sure nice while it lasted!

So far, there haven't been any major dividend cuts outside of just a few oil industry-related companies, so U.S. stock prices have instead been tracking along with investors' expectations for the timing of the Federal Reserve's planned hiking of short term interest rates.

Which is to say that they've risen whenever the news indicates that things are going well enough for the Fed to hike those rates by the end of the second quarter of 2014, and have fallen whenever the news is such that it becomes more likely that the Fed will delay its rate hikes to later quarters in 2015. At present, stock prices, as represented by the S&P 500, are consistent with investors betting on the Fed delaying its plan to hike rates until the fourth quarter of 2015.

Those temporal shifts in investor expectations account for the S&P 500's rocky ride so far in 2015 - at this point, there has been very little change in the amount of dividends expected to be paid out in each quarter of the current year. The only thing that would be worse would be for U.S. companies to respond to the increasing revenue distress they are facing by cutting their dividends, because that would fundamentally change the likely trajectories that stock prices will follow to the downside.

And then, it could be 2008 all over again as everyone waits on pins and needles for the next bad news to drop.

But unless and until that situation actually develops, investors will most likely focus on the world's central banks for their responses to the growing risks of global recession, which means that the market's rocky ride will continue. For now, anyway.


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