The sharp fall in oil prices was the most interesting market news last week. It sends a signal that investors are waking up the fact that the brittle OPEC output deal always was going to be challenged by U.S. producers restarting their drills as prices rose. I am no expert, but this does not come as a surprise to me. OPEC is an unstable alliance, and U.S. producers are governed by one thing and one thing only, price. Whatever detente exists in the global oil market, I am pretty sure that it is a fragile one.  A significant leg lower in oil could be significant for a number of reasons. It could herald the speedy end of the “reflation trade,” which would suit me well. But if it morphs into something more dramatic, we’re back to the story of stress in energy high yield debt, default risks, and perhaps liquidity/fund closure risk in the broader corporate bond market. I am not sure that would suit the portfolio one bit. 

The mini-drama in oil probably won’t deter the Fed from nudging up rates this week, and economists will remain busy contemplating whether to increase their forecasts for the Fed funds rate. Interest rate futures now price in a good chance of four rate hikes this year. Contrary to the euphoria in equity markets, though, the bond market as a whole has sent a clear message on how to interpret this. The curve has flattened, and I think it will continue to do so. I also think that defensive equity sectors will outperform cyclicals in the next three-to-six months. In short; my views haven’t changed that much. 

With that point out of the way, let’s do some modelling. 

What’s your target? 

Equity strategists are in pickle. The S&P 500 has increased too far too fast in the first few months of the year, exceeding many analysts’ year-end targets. This puts the Street’s eggheads in a quandary. If they stick to their targets, they have to assume that the market will fall into year-end from here. Clients usually don’t take nicely to this, though, and many have been forced to go on TV announcing that they are bumping their targets higher. This is relatively simple stuff; assume an increase in earnings growth and a higher multiple, and it isn’t that difficult to find another 5%-to-10% on the index value. 

Is that justified, though?

I have no interest in building a “me-too” bottom-up valuation model for the S&P 500 to verify the street’s estimate, and I am not going to wade into the murky forests of long-term valuations either. What’s left to ask then is whether the rally in S& P 500 is justified based on the movement in other asset classes. In short; what does an arbitrage pricing model have to say? In standard finance theory, the APT framework is presented as an extension to the CAPM, and is based on this 1976 paper by Stephen Ross. The intuition is the same; we are trying come up with a measure of expected return for our asset in question, but the APT model is more flexible.