Oil and the Stock Market
(June 22, 2008)
Dear Subscribers and Readers,
Let us begin our commentary with a review of our 9 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;
9th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 329.31 points as of Friday at the close.
We will update our readers (and “clean up” our text above) of our DJIA Timing System's performance soon after the end of this quarter, and then subsequently move to a semi-annual update schedule. Please refer to our subscribers' area for our March 31st update. As of Friday at the close, our DJIA Timing System is still beating our benchmark, the Dow Jones Industrials Average, on all timeframes since the inception of our system.
First things first. There is no doubt that every stock market trader in the world is now watching the price of oil very closely. As our commentary last weekend implies, the $135 “price signal” of crude oil is not only implying current supply/demand constraints, but also the relatively low confidence among market participants that credible alternative energy sources would be developed in the near future. This view among market participants is exemplified by a recent book (“When Markets Collide”) written by Mohamed El-Erian (co-CEO and co-CIO of PIMCO), which warns of continuing inflationary pressures and higher commodity prices. In the book, El-Erian recommends both institutional and retail investors to increase their portfolio allocations to “real return” assets, such as commodities, infrastructure, and TIPS.
Over the long run, the ability of a society to hold down consumer price inflation rests on three things: 1) productivity growth, 2) labor force flexibility, and 3) monetary, fiscal, and financial system regulatory policy. While Bush's fiscal policy has been relatively loose over the last few years (the latest with the implementation of the $168 billion fiscal stimulus) and thus has been conducive to rising inflation, it is prudent to say that both monetary policy and labor flexibility – combined with the deflation in housing prices and write-downs in the US financial sector – has been deflationary for consumer prices over the last 18 months. In other words, market participants such as El-Erian (and even Vanguard, which has traditionally stayed away from commodity investing) is betting that the “global capitalist engine” is running out of steam, especially within those sectors that produce the basic needs of modern society, namely the agricultural, mining, and energy sectors.
But it is safe to say that no one has a perfect crystal ball (e.g. this is the third time over the last 20 years that George Soros has “cried wolf” on the US financial/capitalist system). And if one is an equity investor, it is even more dangerous to read a publication from a bond guy, even if he (i.e. PIMCO) had been correct on the housing market and its accompanying risks over the last few years! While there are still short-term supply/demand constraints in the global crude oil market (some would argue that it is in the grips of a mania or a “blowoff phase”), my sense is that many investors may choose to “look through” the current constraints in the global crude oil market if becomes apparent that alternative energy sources can credibly compete with fossil fuels sometime in the next few years (as discussed in our commentary last weekend). For now, that is still the $64 billion question, but subscribers should note that since the dawn of the Industrial Revolution and the adoption of the capitalist system by the West, humans have been ingenious in finding technological solutions to the dominant problems in modern history, and consequently maintaining a steady rate of productivity growth over the last 200 years, with the occasional “hiccups” such as the US Civil War, the two major World Wars, and the Great Depression. Out of the many obstacles to global productivity growth today, there is no doubt that lower energy/commodity prices rank as our number one obstacle. In other words, an alternative energy solution – if/when one comes to pass – will provide the global economy the “best bang for the buck,” and will subsequently reward those (greatly) entrepreneurs who can be the “first mover” and commercialize such a solution (most likely, it will be a combination of solutions). The unique capitalist engine of the United States, (and to some extent, Japan, Germany, Brazil, Greater China, India, and Korea), with her significant pools of venture capital, PhD holders, investment bankers, strict patent laws, and a 300 million strong immediate market, is still the perfect candidate for bringing about a market-driven solution.
Unfortunately, whether any credible alternative energy solutions will emerge over the next few years is still not clear today. Based on our research, it now looks like that the year 2010 will bring about the confluence of four key technologies to alleviating our dependence on crude oil: 1) plug-in hybrid technology, 2) more efficient lithium-ion battery technology, 3) commercialization of cellulosic ethanol, and 4) the ability of solar power to reach “grid parity,” although this is not likely until 2011 or beyond (and only if real fossil prices stay at current levels). Such an impact should not be understated. As Clayton Christensen discussed in “The Innovator's Dilemma,” it is immensely difficult for established companies to adopt and commercialize disruptive technologies (even Toyota with its innovative hybrid technologies had to be “dragged” to develop their lithium-ion technology by GM and skyrocketing oil prices). Given that GM, Toyota, and Nissan all now have a 2010 goal to commercialize lithium-ion battery technology, this represents a seismic change in the auto industry – a change not witnessed since the “democratization” of the automobile by Henry Ford. In the meantime, given that crude oil prices are probably in the throes of a mania, there is no telling where oil prices will be over the next 6 to 12 months (the oil price hasn't been responding to its “traditional anchors” such as OECD inventory, global economic growth, etc.).
That being said, I believe that both crude oil and energy prices should at least cool down over the next few months, based on the fact that economic growth has been and is continuing to slow down across the world. That continues to be the message of the MarketThoughts Global Diffusion Index (MGDI). We last discussed the MarketThoughts Global Diffusion Index (MGDI) in our March 9, 2008 commentary (“The Message of the MarketThoughts Global Diffusion Index”) – arguing that the recent rise in commodity and energy prices are due to short-term supply issues and are not sustainable in the long-run. To recap, we first featured the MGDI in our May 30, 2005 commentary. For newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for 25 countries in the Organization for Economic Co-operation and Development (OECD), as well as China and Brazil. Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages. More importantly, the MGDI has historically led or tracked the CRB Index and the CRB Energy Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI by incorporating the leading indicator for the Chinese economy (we have since added Turkey back into the MGDI since the OECD has again started publishing reliable data for the country). This revision is obvious; as China is now the fourth largest economy in the world and has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth last year surpassed that of the US). So what are the latest readings telling us?
Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the Dow Industrials and the YoY% change in the CRB Energy Index from March 1990 to April 2008 (the May readings will be updated and available on the OECD website in early July). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Note the immense divergence of the year-over-year change in the CRB Energy Index vs. that of the MGDI (both its first and second derivative) since September of last year! Given the historical (positive) correlation with OECD growth and the rise in commodity and energy prices since the fall of the Berlin Wall, there is no reason to expect this continued divergence. At this point – it is reasonable to believe that the bulk of the recent rise in commodity and energy prices have been due to speculation, short covering, and the panic over the 1970s concept of “Stagflation,” which few professional economists and forecasters actually understand. More importantly, a significant factor that has provided support for energy demand over the last six months – price subsidies in many emerging market countries – have declined substantially over the last few weeks, culminating in China's announced 18% price hikes in retail fuel prices last Thursday.
As far as Goldman Sachs' very low estimate of demand destruction (64,000 barrels a day in the “high case”) stemming from the recent cut in subsidies in many emerging market countries (including China), my sense is that it is overly optimistic from a demand standpoint. I have read the actual report. Goldman does not disclose the gradient of their elasticity curve (sensitivity of demand relative to prices). For all I know, Goldman may have just plucked it out of thin air since it is very difficult to reconcile the historical data with that of the historical experience. For example, Goldman estimates that these countries collectively consume 19 million barrels a day. With the recent rise in gasoline prices this year, American consumers - who consumes about 20 million barrels a day (about half of which are in the form of gasoline/petrol) - are consuming 400,000 barrels/day less than what they were last year. In a region with relatively low average income, a sudden hike in fuel prices (33% in Indonesia, 50% in Egypt, 18% in China, etc.) is a big deal. Sure, these countries are continuing to grow, but the US is too - especially with the implementation of the fiscal stimulus that began early in May.
Moreover, based on historical experience, the elasticity of demand for fuel relative to income levels - by definition - has to be very high given the exponential increase in fuel demand in these countries over the last few years. In other words, there are still many marginal consumers of fuel in these countries - at least on a scale that they have been consuming fuel in the last 18 months. Given the recent spike in fuel prices, much of this incremental demand should also go away. The 64,000 barrel a day demand destruction (high case) estimate by Goldman is definitely too low. Even though Goldman argues that elasticity of demand relative to price is pretty rigid given historical experience (they cite the November 2007 Chinese hike experience), that is also the same experience in the US as well in November 2007. Interestingly, the recent spike and the demand destruction in the US are saying otherwise. i.e. Unlike November 2007, folks are finally cutting back.
Finally, Chinese airline passenger growth has literally gone off a cliff since the beginning of this year, as shown in the following chart courtesy of Morgan Stanley Research:
Interestingly, the steep decline in passenger and revenue passenger kilometer (RPK) growth occurred well before the latest hike in fuel prices (yes, the Chinese government has been subsidizing jet fuel prices as well). At this point, economists still do not have a good explanation for this decline (some attribute this decline to the decline in travel in the aftermath of the recent snowstorms and the earthquake in Sichuan Province), but it is not inconceivable that Chinese economic growth has been moderating as well, especially given the recent tightening imposed by the People's Bank of China and the slowdown in global exports.
Given the continuing slowdown in global economic growth, the recent decline in fuel subsidies, and a potential slowdown in Chinese economic growth, my sense is that the rise in crude oil prices should at least take a breather over the next few months. Of course, that is only the logical conclusion, as crude oil prices in all likelihood are in the throes of a speculative mania. Subscribers please stay tuned.
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 July 2006 to the present:
For the week ending June 20, 2008, the Dow Industrials declined 464.66 points while the Dow Transports rose 45.20 points. The up tick in the Dow Transports last week was especially encouraging, given that the stock market suffered a very broad-based decline. More importantly, the Dow Transports is still nearly 25% above its mid January lows, and had made a new all-time high as recently as two weeks ago. In addition, given the newfound pricing power by the airlines and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to make new all-time highs sometime over the next few weeks (as long as crude oil doesn't spike to $150 a barrel). Given that the Dow Transports has been a leading indicator of the broad market since October 2002, the relative 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, it will be difficult for the Dow Industrials to sustain any rally going forward. For now, we will remain 50% long in our DJIA Timing System – and will look to add to our position only if the market becomes more oversold or if the technical condition of the US stock market improves (although we are now getting close with respect to the former).
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 2.7% to -1.9% for the week ending June 20, 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:
With the latest decline in the four-week MA, this sentiment indicator has now worked off most of its short-term overbought condition. As a matter of fact, with the exception of the plunge in sentiment earlier this year, this indicator is now at its most oversold level since late April 2003. For now, I am still comfortable with our 50% long in our DJIA Timing System, although we are now getting very close to adding to this long position given the oversold condition in this sentiment indicator, as well as the immense amount of investable capital sitting on the sidelines.
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:
While the ISE Sentiment Index has reversed dramatically since its mid March low, the 20 DMA of the ISE Sentiment Index has consolidated over the last few weeks and is now in the process of working off its short-term overbought conditions. More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years. Given this, the probability for much further downside is minimal. At this point, it would not take much more of a “sell-off” in this sentiment indicator (perhaps a daily reading of below 70) for us to add to our 50% long position (brining us to a 100% long position) in our DJIA Timing System.
Conclusion: While the short-term outlook of the US and global equity markets remain murky, my sense is that the current decline in the US stock market is in a “capitulation phase” and should bottom and resolve itself sometime over the next few weeks. While the Dow Industrials could certainly break through its mid March lows, I am not looking for a dramatic decline from current levels, given the immense of investable capital sitting on the sidelines as well as the non-confirmation of the Dow Industrials by the Dow Transports on the downside. Moreover, I continue to believe that we will at least witness a stagnation of the rise in crude oil prices, if not an outright correction, in the next few months. As I discussed in our last weekend commentary, I fully expect strength to rotate back into US and Japanese equities later this year (in fact, Japan has been experiencing relative strength for the last few months) – especially into shares of “productivity enhancers” in a world of high energy and general commodity prices. This includes technology and biotechnology shares. Finally, US consumer discretionary and retail shares will be a “screaming buy” at some point, but not until we see a further retrenchment in consumer spending and mass liquidation among the marginal retailers, restaurant chains, etc.
In the meantime, the US stock market is now oversold, and should bottom out over the next few weeks and embark on a sustainable rally, especially should crude oil prices correct. For now, I would prefer to stay with our 50% long position in our DJIA Timing System, but should the market get more oversold in the next few weeks, there is a good chance we will go 100% long in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA