Capitulation Among the Oil Shorts?

(June 8, 2008)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 8 most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630;

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

 8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively.

While I believed the US stock market would struggle over the summer when we decided to sell our 100% long position in our DJIA Timing System on May 22nd, I had not expected the weakness to come so soon.  With a NYSE ARMS reading of 2.61 and a NASDAQ ARMS reading of 2.07 last Friday, the stock market is now oversold in the short-run.  Should the stock market experience more weakness come Monday morning (i.e. another sell-off of over 100 Dow points), we would most likely initiate a 50% long position in our DJIA Timing System for trading purposes.  However, chances are that the Dow (which has been one of the weaker major market indices over the last few months) and most other major indices will bounce on Monday.  On a longer multi-week timeframe, the Dow Industrials and the S&P 500 are still in somewhat neutral territory.  Since the global financial markets are still not close to being fully functional (more on that in our following discussion on crude oil) – and given rising inflationary and slowdown fears in many parts of Asia – the “tail risk” embedded in both the US and global stock market still remain relatively high.  As a result, we will continue to remain neutral in our DJIA Timing System, and will wait for the financial markets to “show us the money” before we will get back on the long side again (aside from a potential short-term trading setup tomorrow morning).

Let us now discuss our short to intermediate term views on crude oil prices.  With the latest two-day US$16 spike in crude oil prices over the last two trading days, there is no denying that crude oil is now very overbought.  In fact – as can be seen in the following chart showing the daily spot price of crude oil vs. its percentage deviation from its 200-day moving average over the last 25 years, the price of crude oil is now overbought both in the short-term and in the intermediate term (3 to 9 months):

As mentioned in the above chart, the spot price of crude oil is now about 42% above its 200-day moving average.  Based on this measure, crude oil is now at its most overbought level since early March 2000 – when it was just coming off its all-time, inflation-adjusted lows made in December 1998!  Prior to this “recovery period” of oil prices during late 1999 to early 2000, one would have to go back to late 1990 to witness a more overbought level, right after the Iraqi invasion of Kuwait and prior to the beginning of the first Gulf War.

The overbought situation in crude oil prices is also evident in the bottom panel in the following chart (courtesy of Decisionpoint.com).  The bottom panel shows the ratio of the WTI crude oil prices versus the Goldman Sachs Industrials Metals Index:

Over the past decade, it has generally been a good time to short oil and buy industrials metals once the ratio between WTI crude oil prices and the Goldman Sachs Industrials Metals Index reach a level near 0.30 or above.  The ratio of the WTI price and the Goldman Sachs Industrials Metals Index is now at an all-time high.  Moreover, previous spikes to similar levels (such as March 2003 and August 2005) have always led to at least a short-term (but significant) correction in oil prices.  If one believes that oil and industrial metals prices are both good leading indicators of global economic growth, then there is no reason why the rate of change in these two "indicators" should diverge for any sustained period of time.  While there are definitely supply issues within the crude oil market, one can also argue the same case for various industrial metals.  Furthermore, we know that a significant demand destruction has not only taken place within the OECD countries, but also within emerging markets that have slashed their energy subsidies, including India (which raised gasoline prices by 11%), Malaysia (63% hike in Diesel prices), Indonesia, Bangladesh, and Sri Lanka.  China, on the other hand, is the big player in the energy subsidy arena – but even if China fails to curtail its energy subsidies going forward (it doesn't have to, as its energy subsidies are not putting a dent in its budget), there is no doubt that Chinese economic growth has been slowing down as its export markets slowed and as the Chinese central bank continues to hike reserve requirements (rising from 16.5% to 17.0% on June 15th and 17.5% on June 25th).  Over the short-run, demand destruction will continue to play a significant role (in the US, this is exemplified by the latest cut in domestic airline capacity by all across the board, which would in turn raise prices and cramp airline travel and jet fuel consumption).

Make no mistake, however, we are now also witnessing signs of capitulation among those players who have been on the short side of the crude oil futures market.  Subscribers please consider the following:

1. The balance sheet problems at many commercial and investment banks have made them reluctant to act in their natural roles by taking the other side of crude oil and general commodity speculators, including players such as fully-collateralized commodity funds from PIMCO and the USO ETF.  Up until a few years ago, financial players have traditionally been long (i.e. they took the other side of the natural hedgers such as energy producers) - now, they are short.  Given the breakdown of the roles among financial players, there is no question that the crude futures market (and the corn futures market) has broken down.  Ironically, the general credit crunch – which in turn has led to a slowdown in credit creation and economic growth – has been partially responsible for the latest run-up in crude oil prices.
   
   
2. The balance sheet problems, as well as the relentless rise in oil prices coming into last week and the bean counters' will in forcing "mark to market" accounting on energy producers, mean that many energy producers now have no ability to hedge their production, as many investment banks have become reluctant to extend margin loans to the smaller energy producers.  The lack of hedging "pressure" to counteract the buying power from the index funds has no doubt added to the relentless rise in oil prices over the last few months.
   
   
3. As an extension to points 1) and 2), this has also led the prime brokers to either clam down or cut back on margin loans to hedge funds who want to short oil - thus taking out other significant financial players on the short side as well.  Note that raising margin requirements would not affect the long-side players, as commodity index funds and ETFs are in general, fully collateralized.  If anything, raising margin requirements will put pressure on the short side, thus exacerbating the current rise in oil prices.  Furthermore, the two-day spike in oil prices ending last Friday had all the signs of a capitulation and panic by those on the short side.  I would not be surprised if some energy producers actually went into the market late last week to cover some of their  long-term hedges - as a way to reduce or eliminate mark-to-market losses in upcoming earnings reports.

In other words, the latest spike in oil prices is mostly due to technical rather than fundamental reasons.  With the $5 billion common stock offering just announced by Lehman Brothers, and with Barclays PLC now taping US$5 billion from sovereign wealth funds and potentially acquiring some of the weaker financial institutions (Lehman and UBS were mentioned), my sense is that this extraordinary combination of technical factors in the crude oil futures market is now close to an end.  While crude oil prices may well be higher a couple of years from now, crude oil is definitely now due for a short-term and significant correction.

For those who believe oil prices may now be in a corrective phase, my main suggestion – aside from shorting oil or buy certain stocks in the consumer discretionary sector – would be to take a hard look at the domestic airline industry.  Given the announced capacity cuts over the last few weeks, and given the upcoming merger between Northwest and Delta airlines, pricing power within the airline industry has dramatically increased.  Moreover, many of the domestic airlines are now trading new bankruptcy prices, and assuming that Northwest Airlines announces bigger capacity cuts over the next few weeks, many of these airlines could double in a jiffy.  Furthermore, the barriers to energy in the airline industry (which has historically been non-existent since the deregulation of the US airline industry in the late 1970s) has now gotten much higher, given:

1. The lack of financing in this difficult credit environment - especially financing new ventures in the airline industry.  Moreover, given the latest experiments with JetBlue (George Soros was an early investor) as well as Virgin America (which is predicted to be profitable within three years), my sense is that the appetite for funding new low-cost airline ventures has sunk to a new low.
   
   
2. Boeing and Airbus cannot produce new planes fast enough for existing airlines, let alone new airlines who want to compete in the US domestic field. Also, the older planes that CAL just retired are too inefficient for competitors or new airlines to fly even if they could get the financing to buy or lease the planes;

Finally, even Southwest Airlines - who are 70% hedged this year and 55% hedged in 2009 at $51 a barrel, and 25% hedged in 2010 at $63 a barrel - has been expanding much more slowly than they have in the past.  For those who want to take a closer look at the airline industry, I would suggest looking at liquidity risk first and foremost.  This Morningstar article on the airlines may be a good start.

On a side note, I believe the airline industry is going to serve as the "poster child" for many of the industries that have become bloated in recent years due to cheap financing, the lure of phantom profits, and the fact that they have already tapped the "marginal consumer." The US retail industry, with a relatively high start-up cost and relentless competition, is a great example. But once capacity is cut (i.e. we see many retailers not only file for bankruptcy, but are liquidated) and as long as financing doesn't go back to the cheap era of 2004 to 2006, then it would be a wonderful time to buy retail stocks.  For now, we are still not there yet.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2006 to the present:

For the week ending June 6, 2008, the Dow Industrials declined 428.51 points while the Dow Transports declined 187.28 points.  The Dow Transports remains the stronger index – driven by the resilience of pricing power despite high oil prices.  Moreover, given the new-found pricing power by the airlines, I expect the Dow Transports to make new all-time highs over the next few weeks (as long as crude oil doesn't spike to $150 a barrel).  As a matter of fact, the Dow Transports actually made a new all-time high last Thursday, before succumbing to the $10.75 spike in the July crude oil contract on Friday.  Given that the Dow Transports has been a leading indicator of the broad market since October 2002, this strength in the Dow Transports will need to be respected.  However, without an increase in technical strength in the broad market or in the A/D line of the Dow Industrials, this should be viewed with some suspicion.  Furthermore, the forward P/E of the railroads, which has been a major source of strength for the Dow Transports, is now trading at the high-end of its historical range at 16.  While I continue to believe that the intermediate bottoms made on January 22nd and March 17th will hold, I now prefer to stay on the sidelines and wait for the market to get into oversold territory before again going long within our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased again from last week's reading of 9.7% to 7.2% for the week ending June 6, 2008.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Note that the latest decline in this sentiment indicator only represents the second consecutive weekly decline since the nine-week consecutive rise from its extremely oversold reading of -13.9% in mid March.  While the latest two-week decline has erased all of the short-term overbought situation in bullish sentiment, the latest reading is still not as oversold relative to the readings since July of last year, especially given the continued weakness in our technical indicators.  For now, I am still more comfortable with a neutral position in our DJIA Timing System, and will most likely not establish a long position again until we witness more oversold readings in this sentiment indicator.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

With both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from historic oversold readings in such a dramatic way since mid March, and with the 20 DMA stalling over the last few weeks – and accompanied by a technically weak condition – I will continue to stay on the sidelines for now and wait for a more oversold condition in this indicator before going long.

Conclusion: The two-day spike in crude oil prices at the end of last week suggests that many financial players and energy producers on the short side have capitulated or are in the midst of capitulating.  Coupled with a significant amount of demand destruction in both the OECD countries and in many emerging markets, my sense is that the spot price of crude oil is now hugely overbought and is due for a significant corrective phase over the next couple of weeks.  While crude oil prices can still spike to $150 a barrel or higher in the short-run, I don't believe this will last.

Finally – while a lower crude oil price should be welcome news for the US stock market – the weakening technical condition and the elevated “tail risks” are still too high for my liking.  Unless the stock market or investor sentiment declines to a more oversold level, I would prefer to stay on the sidelines for now.  At this point, I do not have a “target price” for either the Dow Jones Industrial Average or the S&P 500, but at the very least, I would prefer to see a DJIA print of 12,000 or a retest of the mid March lows before we even consider of going on the long side again. 

Signing off,

Henry To, CFA