The continued drop in oil price is hurting oil drilling companies. For example, Seadrill and Transocean (RIG) both dropped a lot. Seadrill (SDRL) had a 40% drop in income. Its stock price dropped 23% today it dropped from $43 a year ago to $16 now, a 63% drop, resulting in a yield of 18.7%. Transocean dropped from $50 to $23.25 in 12 months, and now has a yield of 11.6%. Deutsche Bank expects one third of the high yield oil companies to default on their bonds.
I had warned clients to avoid high yielding energy stocks as a substitute for bonds because the extra yield is not enough to compensate for the risk of a massive 50% or 63% drop in stock prices. There is the potential for a repeat of the 1986 oil price drop when it went down by 67% which would make oil stocks go down even more. The 1986 oil crash led to massive bankruptcies in the oil regions like Texas even though the rest of the economy was growing.
The declining price of oil and declining sovereign bond yields are a strong hint of deflation or recession. Speculators may misbehave in the stock market and overpay for stocks creating bubble but you rarely hear of the same occurring with someone engaging in activities that put downward pressure on oil prices. Bond yields can be warped by Central Banks but there is plenty of evidence that since retail speculators don’t engage in bubble behavior in the bond market then perhaps the low bond yields and low oil prices are a genuine manifestation of the Invisible Hand of the economy that points towards a very soft economy.
Expect continued economic cooling in EM countries like China and Brazil that used too much debt to overstimulate their economies. This will result in a global recession since the driving force of growth is in the EM countries and the G7 countries are close to zero growth, in the aggregate, except for the U.S.
The global economy is integrated enough that if the rest of the world goes into recession then it will be too hard for the U.S. to insulate itself from a global slowdown.
Financial theory claims that one should diversify into commodities, real estate, stocks, bonds. But commodities are going down and on an inflation adjusted basis have been going down for a century. There is the risk that they could go down in anticipation of a recession and thus would not be useful as a diversifier. The only true mainstream asset that are a diversifier are either investment grade bonds or cash. Non-traditional assets like hedge funds, long-short funds, short selling, the Volatility index, precious metals, etc. may be a diversifier but have some risks of non-performance or tracking error or failure to protect against stock market declines.
This is not a good time to own high yielding assets as the risk is higher now than in the past that these assets could plunge in value. Investors seeking yield should not try to get yield through dividends because of the risk of a stock price crash like what happened to oil stocks. The Alerian MLP index AMZ dropped 20% in a few months from August to October 15 but is now only 5% below the high of the year.
Investors need independent financial advice about the risks a commodities crash which is a hint of stock market crash. I wrote an article “Oil price cut to raise GDP but stocks will go down.”