Sunday, February 28, 2016

The Question Every Investor Is Asking

After a long hard day at work, an investor finds himself retreating to his home office to check on his own investments. Sitting beside the dusty keyboard and piles of notepads scrawled with calculations and stock symbols, a magic lamp sits crested by the soft glow of his desktop computer with three monitors. He rubbed the side because that's what everyone is supposed to do when they come across one of these. A phantasmic figure appeared, filling his office, and said, "I shall grant you one answer to any question about the markets." The tired trader slumped in his chair thinking, then finally asked, "Where is the bottom in this crude oil market?"

Now if you were hoping for an answer then you are among the millions of financial professionals that would ask that same question. Just about everyone has contributed their own opinions on when oil prices will reclaim their hefty price tag (including me), but just about everyone has been wrong at least once. I can remember reading tons of articles last year projecting $60 a barrel oil by the end of 2015. Now, it's almost half of that. So research and calculations continue with the disturbing thought that the rebound could creep up on anyone, and anyone could lose out on the opportunity to cash in. 


Perhaps one of the most important vehicles of crude oil prediction is the U.S. government's own Energy Information Agency, This blog has used its data and analysis many times before, and it will continue to endorse it as one of the analytical strongholds of the glut. Weekly, the agency produces a report called This Week In Petroleum which lists supply estimates for the week and interesting figures that show the current state of the domestic energy market. Major news outlets use this agency in its articles about the crude market which translates to price movement in response to the EIA's opinions. Last month, this chart was posted showing their calculated projections for the next two years. In 2016, WTI prices are forecasted at an average of $38 a barrel with Brent at $40 a barrel. A year after that, WTI prices should average $47 a barrel and Brent $50 a barrel. With those $60 projections out the window and the relentless pumping of non-OPEC producers, speculators are expecting saturated markets for longer. As we saw in the current ratios of S&P oil and gas companies, the energy industry is opting for more liquidity with the expectation that prices will weigh on revenue. Their outlook is supported by the EIA's prediction that 700,000 barrels will be added to inventories in the current year. The first draw on inventories isn't expected until the third quarter of 2017,

But we don't care about when prices are getting better if we already know that's going to happen. The true profits come when traders abide by the simple rule "buy low, sell high." If you just found your interest in this article again, the EIA has something for you too. In the weekly report released Wednesday, the focus highlights crude stocks in most saturated regions of the United States. Stocks in the Gulf Coast approached 256 million barrels and stocks in Cushing, Oklahoma set a new record of 65 million barrels just two weeks ago. Any seasonal oil trader knows that inventories typically top in January and February due to refinery maintenance, but that doesn't relax any pressures on the market. In fact, the pressure on oil storage capacity is only rising. With these conditions, expectations for future prices continue to be depressed especially with an increase in Iranian oil considered a sure thing. In comes the term contango, a concept that could help understand where this bottom is. 

A market is considered in contango when the expected futures price is higher than the current spot price. The orange line, which shows WTI contracts from April 2016 to April 2017, is an example of this type of market shape. While it appears similar to a normal futures curve, contango markets are different because the futures price is expected to converge to the current spot price. Because of this dynamic, speculators can buy oil at a cheaper price now while hedging that same oil by selling a futures contract at a higher price. A similar process happened in late 2008 and 2009 when the WTI market was in contango by about $15 a barrel. In the market now, futures prices 12 months ahead have slipped to about $10 a barrel in contango. From February 1st to the 23rd, the EIA reported a spread of about $10.44 a barrel while citing that buying and storing oil does "not typically become economical until contango reaches $10-$12/b." But what does that mean for the bottoming of oil prices? The answer is in the price for oil storage capacity. With stocks consistently rising, capacity will continue to fill up and supply will get tighter. Because most analysts believe that U.S. producers will continue to pump what they can, demand will remain stable. Thus, speculators looking to make a profit of the contango situation will see storage costs increase. When this happens, Financial Times's John Dizard says "peak bear" in oil is close. He projects a "much more rapid rise in spot price in the coming months" because of an unwinding of oil cash-and-carry positions. The precipitation of the gains should occur when storage and the construction of new storage slow down significantly, and this could come relatively soon per the EIA's reported 84% and 89% capacity utilization rates in the Gulf Coast and Cushing respectively. Pressure may also come from a rising spot price that would flatten the curve altogether. As the market begins to stabilize, a convergence towards the yearly average represented by the dotted line would end the contango shape and result in a liquidation of positions. 

Dizard's article refers to a quote from the President of Rosewood Trading that said, "...when contangos unwind, they move very fast...I would say this will happen within a six-month period." Again, market timing is brought up here with predictions of an uptrend in a half a year, but it's important to remember how quick things can change, in both directions. The unruly market has already misdirected thousands of investors because its saturation of uncertainty. The unwinding of a contango market could occur soon but may prove to be unsustainable as a trend. It's important to monitor capacity utilization and inventories in order to recognize a false bottom if one forms (like in early 2015). A contango situation could resume after a strong recovery if fundamentals don't improve and the rent for empty storage tanks drop in price. Interest rate hikes (or the lack thereof) may also affect cash-and-carry positions as they increase the cost of getting the capital to rent the tanks. Low rates could translate to more contango while a few hikes signal the bottom.

The genie might not be clear with his answer, and if his name is John Dizard, he might not even be that accurate at all. However, a contango market can be quite telling. The unwinding of the contango crude market in 2009 led to some of the highest prices ever seen. While the 2015 and 2016 contango market is not as extreme, its length is much longer. The accumulation of carry positions over this time could lead to a bottom and then a rebound, shooting the sprice up to its 2015 yearly average of $42.98 in the graph above. For that reason, following the shape of the oil futures curve can provide us with some insightful information...and something to do in place of looking for that golden lamp.

Wednesday, February 24, 2016

The Current Debt Crisis

Predictions from various organizations regarding crude oil have a tendency to affect investor sentiment more often than the actual fundamentals that the price represents Most recently, the IEA has projected the faltering of many sources of production in the coming months. As daily pumping wanes, the prices should recover later in 2016 as the stabilization process begins. WorldOil reported that exploration companies have already cut capital investments by 17% off of the previous year's level. The trend should continue as volatility keeps prices in the low $30's going into the end of the first quarter of 2016.

In the United States, oil contracts closed at $32.15 on Thursday still about $7.00 dollars from the closing price of 2016. Brent crude oil closed at $35.07 on the same day trailing its high by $4.00. Iranian oil and a slower than expected drop in U.S. output has caused suppressing sentiment to hold prices around its current trading range. Despite support for an OPEC-wide output freeze and a record gain for crude oil price in late January, stronger bearish volume has countered weak rallies that smell more like short closings than solid reversals.

The price dynamics are interesting, but let's look at fundamentals and balance sheets instead. In the past year and a half, headlines on major financial news outlets have highlighted large spending cuts by oil and gas companies regardless of market capitalization. Reported by the same WorldOil report, a 25% cut in investment spending by Exxon-Mobil, the largest oil company in the U.S., shows the trend that most energy companies are regressing towards because of their vulnerability to the drainage of revenue channels. With about 1,000 rigs stalled, hundreds of companies are forced to find other sources of revenue...or just lose that stream altogether. Because of the loss of capital in the market, billions of dollars of debt are being called into question, and the focus is now shifting from profits to survival. 


An important part of staying on the right side of debt is managing the levels of leverage on which the company operates. The spreadsheet above (available for download using the button in the bottom right-hand corner) looks at the current ratios of the energy companies listed in the S&P 500. These forty companies serve as representative fundamentals for most oil and gas companies. The list includes Chesapeake Energy, whose stock has plummeted because of vulnerability to debt, and Noble Energy, another company struggling with coal and oil prices. Each individual corporation should be looking to monitor their debt levels so that they can survive a period of lower revenue. Doing this prohibits most forms of growth. For example, every extra dollar paid toward interest accruing on a loan cannot be used to discover another underground reserve, Not only is it common sense, but it's an idea that can be used to analyze the trend in expectations that most oil and gas companies will follow. A firm's credit exposure will typically depend on what their own projection for crude oil price is. Bearish outlooks would result in getting rid of debt while bullish outlooks might inspire the opposite. The data above appears to support the former. All but two energy companies dropped their current (short-term) liabilities in 2015 showing the acknowledgment that tough times were here to stay. An average change of 28.6% in the current assets-to-current liabilities ratio accentuates the argument that most firms are predicting low oil prices to stay. Current assets and liabilities are used in this fundamental calculation in order to show changes in leverage inside the next year. Thus, the restriction allows us to look at price trends within the next year. Most firms see reducing debt as a necessity for the next year as all but ten of those listed increased the current ratio which compares solvency levels inside an industry. Eight of the constituents took an even safer route as their current liabilities dropped and their current assets increased. These cautious members accounted for most of the ratio increases with a 77.5% increase among them. Those who saw assets and liabilities both go down only averaged an 18.5% increase in the current ratio.

Despite the variability, the data clearly shows a tightening that is continuing to put more pressure on the energy sector. Less debt means less capital to fuel research, development, and exploration which will inevitably lead to less productivity later in the cycle. The trend analyzed above shows us that firm's expectations for the next year are bearish, and projections for revenue will remain low until a substantial rally is evident. At the same time, there is division in the bearish sentiment with firms that are stocking up on cash (up assets and down liabilities) predicting a long-term supply glut and firm's just reducing debt (down assets and down liabilities) predicting a somewhat shorter glut. Using this knowledge, traders can pick a company that best suits their own projections for crude oil prices. The current ratio measures a company's fundamental balance sheet strength which provides insight on how solvent they can be given an abrupt crash. When the glut starts to slow down, successful companies will utilize their healthy balance sheet by adding more debt to support growth at higher prices. But only then can we know which debt strategy will be the right one.

Monday, February 22, 2016

The Fed's Shaky Voice

Last year, the Federal Reserve all but solidified up to four quarter-point rates hikes paired with their positive economic outlook. They based their diagnosis on strong job gains and stable industrial indicators with a careful eye remaining on the low inflation. But that was last year. During the January meeting, Fed officials chose not to raise rates even though only a small quarter-point increase was due. Instead, Yellen and friends blamed volatility on the increase at the end of 2015 coupled with uncoordinated action from the worlds' largest central banks.

The January minutes, that were released on February 17th, allow investors to peek into a very tense, unsure FOMC board that is left with a nonexistent arsenal that they can use to fight the current weaknesses in the global economy. Their words appear to be all they have left in a fight with a trembling global economy. Although, time and time again, the Federal Reserve board finds itself insisting that inflation will eventually rise to where it should be and economic prosperity will follow. The uncertainty surrounding energy prices is once again referred to as the blame for low inflation, and the staff at the Federal Reserve has yet to find a way to placate the worry. Instead, the committee continues to insist upon a 2% inflation outlook that has been pushed back to 2018. In the past year, statements about inflation such as this have become cliches seeking to remedy market turbulence. Commentary is all that the Fed can muster in fighting the deflationary prices as forecasting and analyzing an energy trend appear out of the question.

Far more interesting, perhaps, is the following statement drawn directly from the minutes: "the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary." Typically, the goal of the Federal Reserve is to maintain a healthy balance of inflation and unemployment as dictated by the Phillips curve. If it does this, the institution remains in a good political light. This statement claims that the Federal Reserve has found itself in a bind where inflation and unemployment are behaving similarly. While some call it the "new normal" of slower growth and less productivity, the Federal Reserve must seek to optimize both. The possibility that crude oil may never recover to its original status as the staple of the industrial world describes the potential for a larger paradigm shift. The Fed has disregarded this option as a potential change in the dynamics of inflation and chosen to believe in a recovery. Ditching a plan for potential rate hikes in 2016 can be a dangerous response that has been conditioned by historical data. The Fed may appear to be taking action and changing the financial conditions, but the current market is out of their reach. The FOMC no longer has any weapons in the fight for inflation stability and unemployment optimization. Because the Fed Funds rate has been left so low, the unhealthy change in expectations has endangered investor capital. The inverted yield curves and record low Treasury bond rates have forced lower returns and lower expected returns in the near future. The Federal Reserve should focus on raising rates gradually so that investors can exit equities when they need to and generate a higher yield in fixed income. Meanwhile, they should acknowledge that mitigation of the current inflation and employment trend is futile while conceding to the possibility of major shifts in energy trends.

From Conference Board


Pictured above is a chart following Conference Board's leading economic indicator index over the past 17 years. The latest press release came out last week with January's index falling 0.2% from the December level. Compared to previoud peaks before recessions, both the blue and red lines appear to be closing in on a similar pattern which could mean that one is on our doorstep. The Federal Reserve had other projections. GDP is expected to resume a healthy recovery fueled by increases in consumer spending as inflation begins to recover. Credit and capital markets appear minorly squeezed with risky assets being avoided, a trend not expected to last. Does anyone else find the rosy remonstrations in the minutes a little much? The past two Chairpersons of the Federal Reserve took large steps to encourage transparency in the monetary policies that were developed there. Press releases and interviews are accompanied by staff projections that seek to "guide" the market as the Fed thinks it should. The January minutes even have a whole paragraph written about a discussion of the inflation target and how miscommunications can lead to misdirection in the market. Inflation targetting was not suggested by Bernanke as a way to bully the markets into accepting a given rate of inflation; instead, the old chairman suggested it be used as a tool to adjust expectations. Yellen's Fed has misunderstood this. The constant reiteration of the 2% inflation rate has made investors place too much weight in this indicator which is something that the Federal Reserve only has small amounts of power over. Monetary institutions should center their communication around interest rates and pricing capital and credit because they can directly control this. Using an unconventional technique such as inflation targeting can upset the stability in market expectations and have the opposite effect. The minutes from January show that the Federal Reserve has continued its attempts to "coax" the market into stability and "control" inflation by the assigned target. These practices are unhealthy and have lead to incompetencies in the actions by the Federal Reserve. Hopefully, this year they will be recognized and corrected.

Tuesday, February 16, 2016

The Real Goals Of Russia and Saudi Arabia's Deal

The newest talk over the oil-cooler (yes, I opened with that) in the offices' of hedge funds and investment banks is Russia, Saudi Arabia, Qatar, and Venezuela's new deal to freeze oil output at January production levels. The news prompted oil prices, both WTI and Brent contracts, to set single-day records for the gains at the end of last week. Despite prices rebounding above $30 (WTI) and $36 (Brent), the door closed at $29.04 and $33.48 a barrel respectively.

The deal between the oil producing giants brings a lot of ambivalent sentiment onto the trading floor. While a production freeze signals bullish news to commodity traders, the market will remain oversupplied at January output. The exact production numbers cited as January levels are as listed: Saudi Arabia at 10.2 million bbl a day, Russia at 10.9 million, Venezuela at 2.4 million, and Qatar at 680,000. The freeze didn't fool investors who saw it more as deceitful as large gains were pared to the smaller ones that are seen at closing. The numbers for Saudi Arabia and Russia are some of the highest they've ever posted. The deceitful announcement was established with three goals in mind: increase oil prices, retain market share, and decrease competition

Accompanying the officials from the four countries was Saudi oil minister al-Naimi attempting to augment the effect that the deal might have on oil prices. His words fell under the looming ghost of OPEC's dirty history. His endorsement slathered the outlook for oil fundamentals with the exaggerated enthusiasm for which OPEC's officials are famous. In Doha, al-Naimi cited the deal as the "beginning of a process" with hopes "to stabilize and improve the market." His hints at a follow-up might have been translated as a broader output cut conducted by the totality of OPEC member nations. The validity of such a statement is entirely in question with quotas assigned by the cartel often being ignored by its constituents. The oil minister continued to support the deal by saying that Saudia Arabia and Russia just wanted "to meet demand" and "a stable oil price." The demand comment struck me as curious. Even though the China Caixin Manufacturing Index rose to 48.4 last month, the indicator has been in contraction since March 2015, and the oil markets were oversupplied then! 


From TradingEconomics.com
Both Saudi Arabia and Russia knew that this deal would give U.S. producers a reason to hope as prices would no doubt rise sharply on this bullish news. With that knowledge, the countries involved with the deal intended to send a subtle message to those other producers while forcing their wills on the market. OPEC protocol typically demands a production cut or a quota that is anywhere from 2%-5% lower than current production. This play was certainly different. Freezing oil production allows the participants to establish a set production level that they know will allow them to stay competitive. At the same time, it gives the expectation of some retreat alongside an invite for other parties to come to the table because it's those producers who matter more at this moment. If the choice to pump or not pump oil is modeled by a game, one can say that Russia and Saudi Arabia took away the game of asymmetric information that leads to the producers' decisions to pump limitlessly. In place of that, other producers are given a choice with the knowledge of what Russia and Saudi Arabia will do in the future. With that knowledge, the individuals in the oil market can figure out how to maximize their own revenue, and clearly, cutting production achieves that goal. All the while, Russia and Saudi Arabia get to solidify their market share at record-level outputs and rising prices. How clever.

from Bloomberg

Closely related to the goal of maintaining market share, the last goal of the deal is a reduction of competition in the market. As the market continues to get more and more oversupplied, the blame for who is causing the glut has shifted over time. First, shale producers were blamed for their ascension in 2014 and incessant pumping into 2015. Over the course of 10 months, U.S. oil producers grew
 from 8,692,000 million bbl a day in June of 2014 to 9,701,000 in April of 2015, an 11.6% increase. By the middle of last year, their market share was established, and traders turned to the increases from OPEC production as to fault. When investors expected cuts, the cartel boosted their output from 30.77 million bbl a day in 2014 to 31.60 million bbl a day in 2015, an increase of almost 1 million bbl a day. Dissention between members in South America and Africa and their Middle Eastern companions heaped stress and uncertainty on the hopes for a deal. Oil prices then tanked going into 2016 as a divided cartel meant more competition in the global market for crude oil. The spotlight shifted one last time as a nuclear deal with Iran was developed and implemented taking away the sanctions that kept them from exporting oil. This deal addresses these smaller oil exporters (Iran and Iraq specifically who have political reasons for increasing production) and attempts to convince them to cut output. Some analysts are even citing the possibility of U.S. producers organizing a coordinated cut in order to make oil prices move higher. Essentially, Saudi Arabia and Russia have "thrown the ball in their court" enticing their competitors to back down with the potential profits of higher prices.

Is the oil rout finally at its end? Have we found a bottom for the troubled oil markets? The outcome of this deal remains unclear with the specter of dishonesty heavy in any deals concerning Russia and Saudi Arabia. Investors should continue to monitor the plans of Iran and other smaller Middle East countries to see if a coordinated cut could be organized. U.S. producers, on the other hand, will face an inevitable production drop as revenue levels remain low and pumps must close.

Sunday, February 14, 2016

The Deviation Moving Average

In a previous article, the concept of the equilibrium price was discussed with reference to supply and demand dynamics upon which most mathematical economists agree. Analysts and pundits who throw rough numbers around in news articles and reports are trying to find that magic number that prices may converge. The value could be based on a calculation or a suave observation of historical price movement that suggests a certain number. Often times, these technical and fundamental projections guess at what a "fair price" would look like. A "fair price" meaning that the value reflects what the investor is paying for and how much it may benefit that individual in the future. Any trader knows, though, that actual market price and the "fair price" are dramatically different things, so many analysts turn out to be wrong.

The discussion of what the difference between a fair price and the market price is divided into two viewpoints that see the price mechanism differently. The efficient market hypothesis is the mantra of fundamental heavy analysts and investors that believe all information is reflected in the market price of an asset. The idea is hinged on the belief that information is symmetric and all players have access to the same information while making their decisions. In that way, a price will always converge to a fair value because most if not all investors are rationally buying and selling the asset based on its integrity. Th antithesis of the efficient market hypothesis is best explained by Burton Malkiel's A Random Walk Down Wall Street. His book argues that idiosyncratic trading leads to under- and over-valuation of securities leading to the taking of profits through arbitrage. Technical traders believe that these irrational prices develop through patterns and are lead by various signals. Therefore, this school looks to trade assets based on their perceived price that is communicated through the market price. The fair price has little to no value in a technical approach.

So in reality, what is the best way to predict prices? I believe a mixture of the two may be the best way to forecast prices. Using historical price trends, the Deviation Moving Average indicator may be able to paint a picture of where the actual, market price is relative to an estimation of what the "fair price" looks like. The truth is intraday fluctuations that are heavily impacted by shifts in trading mentality rarely ever trade at a fair price. Instead, assets consistently deviate from a reasonable price that can be constructed by a moving average. Traders often look at these moving averages when trying to establish a base trend that estimates the fair price given by the herd of investors that manipulate the asset's value through constant buying and selling. Those moving averages aren't actually what investors and analysts say are efficient projections; they use the trendline as a way to generate signals based on the deviation (or lack of deviation) shown in the market price. The deviation moving average takes the idea of deviation and applies it to a model that can produce buy and sell signals and an algorithm that generates a rough forecast for price.


The chart above shows the spot price for WTI contracts sold out of Cushing, Oklahoma with the deviation moving average calculated using a 50-day price moving average and a 10-day deviation moving average. The blue line tracks the daily movement of the contract over 2015 up to the beginning of this year. The orange line shows the indicator's movement over that time. The calculation used to produce this line is based on the idea that market price will always deviate from a rough estimation of the fundamental price. While the day-to-day deviations are relatively different, a moving average of those values shows a suggestion of what traders thought a reasonable deviation was. When the blue line crosses over the orange line, as seen in late February and early March, investors start to value the asset closer to the 50-day average. Crossover points in the other direction, such as movement in early May, shows that traders are enlarging the current deviation between the market price and the rough estimation of the fair price. As the scales are shown to be far apart, this indicator would be unsuccessful at developing insights about short-term trends. Instead, the short-term trends themselves drive the accuracy of the long-term accuracy.



Fluctuations above and below the orange line are inevitable and act as a sort of momentum indicator. The farther the blue line moves in one direction, the more likely that it will snap back towards the deviation moving average. In the graph above, it is noticed that the largest spikes in difference between the indicator and actual price (or just the deviation) are followed by a slope towards a difference closer to zero. The spike in February shows this property as well as those in July and September. A trader looking at this indicator will always know that prices will return to the calculated deviation moving average because that trendline does not follow the overall moving average of the price but the overall moving average of the deviation which can play a larger part when trying to find signals of over-bought or over-purchased securities.

Using this indicator as a tool for rooting out possibilities of a reversal is tricky because a trend in deviation could easily be reversed and deemed illegitimate soon after. For this reason, major reversals should be confirmed using other tools that measured different technical and fundamental aspects of the security. A reversal signal may also be unclear because of the volatile movement of the calculated price in an intermediate range. On the first chart, a crossover point above the blue line might be associated with a reversal upward until a possible peak (where the sell signal would occur). In place of a peak materializing, the price and the deviation moving average moved up with each other until another crossover point downward occurred at a price almost $10 higher. A combination of the two charts above along with an analysis of their patterns may be more helpful in discerning between viable signals and the phony signals.

Earlier in the article, it was mentioned that the indicator uses both fundamental and technical analysis to come to its conclusions, and some explanations referenced the plain "50-day moving average" as the part of the calculation that brought in a fair, fundamental price. This can be pointed out as an idiosyncrasy because the 50-day moving average actually never references fundamental data inherently. Indirectly, though, a 50-day moving average taps into the hundreds, thousands, and maybe even millions and billions of trades that occur in those sessions, Like the efficient market hypothesis says, those trades hold thousands of hours of research from millions of investors, and because those opinions and information are being averaged out, the price slowly approaches an approximate fair price which is developed by the perception of fundamental data. This indicator works relatively well at communicating that fair price, but alone, it neglects the clear evidence of irrational trading that causes the deviation. In these ways, the deviation moving average marries the ideas represented the efficient market hypothesis and behavioral finance, rationality and irrationality, and finally, fundamental analysis and technical analysis.

After further analysis, there's no doubt that there's more to this indicator than meets the eye. A second look at the chart of the differences reveals a patter in the deviations of daily prices from the calculated price. The fluctuations resembled a trigonometric function that shows harmonic motion and the cyclicality of the asset pricing mechanism of which investors know and love. Stock prices appear chaotic on a chart, and in reality, their movements are too volatile for accurate predictions to be developed from simple averages. A smaller moving average may appear to do the trick, but shrinking it too small reduces its ability to extrapolate. The deviation moving average model does not seek to predict prices using past prices but constructs projections based on the deviations from those averages. Finding a model that predicts an approximate deviation for a certain day can then allow an extrapolation for price as the projected deviation from the moving average. The model tracks the movements in the current trends using the 10-day moving average of the daily deviation so that large sentiment shifts are accounted for.

Projections for the next five trading days will be listed on a page linked to the blog, but here are the first few numbers that the model has spit out.

Next 5 WTI closing prices

The model predicts a peak in WTI price to occur on Monday with a reversal in that trend and movement towards $20 a barrel by Friday. Please remember, these are not predictions that I came up with, rather they are extrapolations from a model that I developed. Thank you and have a good weekend.

Tuesday, February 9, 2016

The Winning Sector and Why

Another day of unsure trading left stocks to move ambivalently today as crude oil fluctuated below $30 and major market indices floated around their opening prices.

After higher supply estimates by the International Energy Agency, traders once again found reasons to sell stocks across the board. West Texas Intermediate contracts which opened at $30.17 fell to just 20 cents off their low at $27.94. Analysts continue to point to a coordinated cut by major oil exporters as the only remedy to low oil prices, a point that is rebutted once more by increased production from OPEC. The International Energy Agency reported that the cartel added about 280,000 extra barrels onto the market with sanctionless Iraq ramping up output in order to join the relentless hunt for more market share. With every day of depressed oil prices, price projections turn bearish and volatility appears to increase. Before this year, only a select few would have guessed contracts could be valued so low.

Because of all the bewilderment over crude oil, suppositions about global growth are being called into question as well. Just as WTI crude has lost just over -25% this year so far, the S&P 500 has dropped -7.91% and the Global Dow has plunged -11.05%. The largest losses have come from European countries saddled with debt and emerging markets in a similar situation. Greece's stock market, the Athens Stock Exchange (ASE), reached a 52-week low today while boasting a -28.59% YTD performance so far. Equities are mostly falling in response to a debt problem that has been alluded to here multiple times. The popular U.S. treasury bond is slowly approaching the bearish signs of an inverted yield curve as 5-year, 10-year, and 30-year U.S. bonds saw their yields drop while 3-month and 2-year notes remained the same. Needless to say, there are large amounts of uncertainty surrounding the future with daily losses adding to the negativity.

What if I told you there are some stocks that appear impervious to these weaknesses? Is there a winner among the losers? And could it be a whole sector? Well, there might be something like that, but its performance isn't explained by strength in the sector, but rather, the cyclical nature of its trading. The Dow Jones Utility Average beat the Total Market average with gains of 0.67%, but that's not even the impressive part. As about 78% of S&P stocks trade below their 200-day moving average, the DJ Utility Index trades around its 52-week high of 629.68. The sector's year-to-date performance is 8.53% in a year that is so heavily defined by weakness and volatility. This deviation can be attributed to a utility stock's tendency to have a lower beta (volatility versus the overall market) than other equities (AEP, a member of the DJU). Because utilities like water and power are supposed as necessary, their financial integrity is less likely to weaken in economic downturns. On top of that, they tend to pay out good dividends with less uncertainty on the price tag. As volatility hits stocks that are more vulnerable to demand and supply shifts, investors rotate their money into stocks like these that can provide more safety than their peers in other sectors.

The utility sector has been in a long slump relative to the major large cap equities in the S&P 500 ever since the crisis in 2008 and 2009 where they had peaked. The long six to seven-year bull market saw the growth of stocks that were more vulnerable and volatile because of easy monetary policy and a cheaper dollar. In 2015, the characteristics of the bull market started to fade away with two tests of the resistance on the ratio chart. This year, the ratio broke through the long-term trend line as money flowed into the less volatile sector. This trend appears sustainable at first because of the uniqueness of such a move, but there may be more behind the move.

Michael Gayed's book Intermarket Analysis and Investing discusses the connection between fundamental, technical, and economic trading. The premise of his book is that a combination of the three kinds of analysis is the best way to produce projections and insights with the most accuracy. Using Dow theory, Gayed shows a connection between the Dow Jones Utility and the trend in interest rates as an insight into the health of the overall market. When interest rates rise as they do in an overheated market, utility stocks lose their capital to other stocks that are on the rise. As interest rates fall, utility stocks benefit from the volatility that usually causes the interest rate cuts. In short, utility stocks typically lead the rest of the market where a peak from the DJU might signal a peak in the DJIA and a trough would signal a near future trough.


The chart above shows the rough trend that can be extrapolated from a comparison of the DJIA and the DJU. So what's next? In the past year or so, two peaks and a trough have been lead by utility stocks and the interest rate trend appears to be convoluted with divergence among the world's major monetary institutions. As for the Federal Reserve's stance, its plan of three quarter point interest rate hikes has stalled with major stock market losses threatening a recession. The sudden and large jump in utility performance shows that investors are predicting interest rates to remain flat for awhile or a reversal of the December hike could be on the cards. The sentiment is exceptionally strong especially given the large period of time that rates were held near zero. There's no doubt, though, the solid dividends from utilities are in high demand in the current trend, so they could be easy buys going through the first two-quarters of 2016. The three instances where utilities lead industrials correctly are significant as well. A gap of about one to two months between the DJU and the DJIA appears to be the norm for the current intermediate-term pattern. Because the move in early 2016 was so strong, the gap between the two possible future peaks could spread out to three to six months. Confirmation is important, so look to see if interest rate hikes are planned and economic health has been restored before projecting a reversal from the DJIA. As for trading utility stocks, long positions in the short term and hold positions in the long and intermediate term.

Saturday, February 6, 2016

Bernie's Wall Street

In every country, national and international politics play key roles in the development and sustenance of the economy. Geopolitical conflicts have long been a source of financial crises. The institution of OPEC is a clear example of the way political conflicts over oil can cause swings in the stock market and, hence, the overall economy. Many financial analysts forget to include such analysis in their reports, and investors should be wary not to do the same. The presidential election of 2016 may have major implications for fiscal and monetary policy in the near future. Because the stock market and its assets are supposed to include expectations for future business conditions, investors should recognize that certain fluctuations and trends can be affected by political events. The Iowa caucus, and potentially the New Hampshire primary, are two events that have the potential to add volatility to U.S. and global markets already in turmoil.

Instability could be further augmented by the continued success of Bernie Sander's so-called "political revolution." His agenda filled with hefty government programs, lofty increases in the minimum wage, and verbose calls for equality reminds some voters of a socialist, and not all of them are mad about it. In the Iowa caucus, the oldest presidential candidate won the state's 17 to 29-year-old voters by about 70 points. For perspective, President Obama won the same age group by 43 points in 2008, and when on to win the entire election. On the other hand, Hillary Clinton was the favorite of 45+ voters taking a significant chunk of her support from Sander's own age group. The implications of these specific numbers reach beyond the 2016 election; instead, they represent a fundamental generational change in what is called Generation Y.

This Generation Y, which has been seduced by a suave grandpa-like figure offering more in wages and less in debt, is the same one that survived the financial crisis of 2008 and the Great Recession's economic apocalypse. They are riddled with student debt and low-paying, unskilled jobs, circumstances Sanders can take advantage of for extra votes. So is this just a convincing, articulated senior citizen an appealing political figure or an actual paradigm shift in the way this generation thinks? The large amount of young people that have turned up to vote for Sanders shows their support for his radical policies, and his talk of a political revolution suggests a deep-rooted desire for change. The generation, who has felt so trampled by Wall Street and the economic beasts higher up on the food chain, finally has a voice. The implications for the political establishment and the economy are already hurting Clinton who has been hurt by her ties to big cooperations and a tamer view on regulation.


A look at a graph of the S&P 500 and Bernie Sander's poll ratings may describe some of the forces behind his support. In 2015, large cap stocks were relatively flat in the first half of the year as Sander's support grew steadily to about 25%. In late August, the stock market saw its first major drop in the past year when the Chinese economy revealed its first hints of weakness. Curiously enough, polling data for the Democratic candidate shoots up in the following month to over 40%. Televised debates, the only major public events which could have spurred such an increase, were not scheduled until the month of October. The recognition of further economic weakness, as well as tragic interest rate policies from the Fed, could have played a part in what looks to be a reaction to stocks plunging. Young voters, in college, grad school, or in search of a job, respond to these stressful sentiment changes quickly because of social media and the financial headlines. Bernie's support remains in the 30-40% range in te polls through the end of the year. In January, the market takes another turn for the worst and the poll ratings jump to 49.6% where he falls short to Clinton in the Iowa caucus. The chart shows support for Sanders in all age groups, but the young voters have comprised a majority of his following throughout the campaigning season. The trend represents a growing aversion to the private sector that was formally represented by the Occupy movement, protests on Wall Stree that were largely organized by young adults.


Over the past 30 years, the Federal Reserve has been radically changed by this wave of anti-"financial establishment" feeling. The Fed Chair has transformed from the deregulated Greenspan era to the calculated administrations of Bernanke and Yellen with the Dodd-Frank Act looming in the highlight reels. The young consumer and tentative investor are fed up with establishment government dealing with the greed on Wall Street. Voting for Bernie Sander's gives them the direct message they want to send. Hedge funds and individual investors might be receiving these messages with a small amount discounting present in XLF (S&P Select Sectors Financial Services) from the overall market. A positive trend for Bernie Sanders would spell disaster for investment and commercial banks with "Too Big Too Fail" labels that could become toxic. A Sanders administration would be anti-Fed and anti-big bank. Support for his plan to reinstate Glass-Steagall would turn into chaos on Wall Street. Stock prices would drop and capital markets (like the commercial paper market) might experience a jump in prices threatening an already unstable economy.

While holocaust-like symptoms are unrealistic, an increase in uncertainty surrounding that industry and, in turn, capital markets, is almost guaranteed. The Generation Y that supports Bernie Sanders has a new idea of equality, income equality, that differs greatly from the opportunity equality Generation X demanded. Increases in taxes and fewer perks for money managers are ideas with which the majority of youngsters in Iowa would agree. Because of the candidate's value of honesty, the financial services industry would be forced to deal with more transparency and government regulation as retribution for the crisis in 2008. His policies will bulk up the public sector with plump budgets supplied by higher tax revenue. While those tax dollars would appear to recycle back into the economy, a burst of government expenditures would only have short-term benefits as it crowds out necessary business spending. In the end, discounting of stock prices would not only be evident in the financial services sector but throughout the equities market as a whole. Investors cannot underestimate the rise of Bernie Sanders and his implications for the political economy. Socialist policies may be more welcomed than usual by the crowd he's attracting.