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Crude Oil Market Remains Challenged

(May 17, 2009)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 8 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 3,903.36 points as of Friday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,594.36 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250, giving us a gain of 1,018.64 points as of Friday at the close.

As our subscribers should know, we have consistently viewed Eastern Europe as one of the weak spots of the global economy since the current financial crisis began in late 2007.  Specifically, we view the region as a source of systemic risk – as the region has experienced both an asset bubble and had accumulated a historically large amount of foreign-denominated debt over the last five years.  In many ways, the situation facing Eastern Europe coming into the current crisis was no different from what the “Asian Tigers” faced in the summer of 1997.  For the new subscribers who are not familiar with the headwinds facing Eastern Europe (along with the exposure to the region of many Western European banks), our April 26, 2009 commentary (“The April 2009 Global Financial Stability Report”), and May 3, 2009 commentary (“Will the European Delivery be a Dud?”) should provide a good background (for a more extensive background, subscribers should read the full version of the most recent IMF Global Financial Stability Report).

That said, we also asserted that the most recent IMF and World Bank aid programs should be sufficient to “prop up” the Eastern European economies at least through the summer.  The recent shift by the European Central Bank to a more dovish policy (by adopting a “quantitative easing” to purchase 60 billion Euros worth of covered bonds) is also encouraging.  Most recently, sovereign spreads across the entire European region (Eastern, Central, and Western Europe) have narrowed.  In addition, the latest OECD Eastern European Composite leading indicator (which is composed of four countries in Eastern Europe, specifically, the Czech Republic, Hungary, Poland, and the Slovak Republic) is showing some signs of life, as illustrated by the following chart courtesy of the OECD:

OECD Eastern Europe

Note that Hungary has already received IMF aid, while Poland is scheduled to receive IMF aid in a matter of days.  The fact that the leading indicator for OECD Eastern Europe (blue line) is turning up is encouraging, as this shows Eastern Europe could recover without additional IMF aid (Poland has not yet received IMF aid, while the two remaining countries, the Czech Republic and the Slovak Republic, have not indicated the need for it).  More importantly, Dominique Strauss-Kahn, the chief of the IMF, recently acknowledged that the IMF had overestimated the indebtedness of the Eastern European region – suggesting that the systemic risk in the region is lower than originally projected.  Not only is this bullish for the region, but it is also bullish for the global financial market as well, as a benign adjustment in Eastern Europe would eliminate a significant “tail risk” in the global financial market and economy.  I expect the IMF to update their Eastern European outlook sometime in the summer.  We will provide you with the most updated information as soon as it is available.  For now, the Eastern European “collapse scenario” is off the table.

With the Eastern European “tail risk” off the table – and with most analysts now expecting global GDP growth to turn positive this summer – energy prices should stabilize or rise as we head towards the 2009 hurricane season (starting on June 1st).  Over the longer-term, however, the crude oil market remains challenged.  As the EIA recently reported, “the current weakness in global oil markets is driven not only by demand weakness, but also by additional supplies from both non-OPEC and OPEC members.”  Specifically, OPEC's surplus crude oil capacity has increased from just one million barrels/day in mid 2008 to an estimated 4.3 million barrels/day in April 2009.  The EIA projects OPEC's surplus crude oil capacity to increase to over 5 million barrels/day by next year.  Meanwhile, the Gulf Cooperation Council (which includes Bahrain, Qatar, Kuwait, Oman, Saudi Arabia, and the UAE) has continued to increase its upstream oil and gas investments, particularly in exploration and development projects.  According to Proleads, a Dubai-based research firm, there has been a 9% increase in upstream investments over the last 6 to 9 months, with the UAE increasing its upstream investments by 30% from last June.  As a result, OPEC should continue to increase its total crude oil production capacity in 2010, and beyond.

Closer to home, non-OPEC supply is projected to rise by 100,000 barrels/day this year, despite production declines in Mexico, the North Sea (the UK and Norway), Russia, and Egypt. Specifically, the supply increase is due to projected production increases in Brazil, the US (from 4.96 million in 2008 to 5.20 million barrels/day this year due to the Thunder Horse and Tahiti offshore platforms coming online), Azerbaijan, Kazakhstan, Sudan, China, Colombia, Vietnam, and Canada, as shown in the following chart courtesy of the EIA:

Non-OPEC Crude Oil and Liquid Fuels Production Growth (Change from Previous Year)

Interestingly, Suncor's CEO recently asserted that its marginal cost of production for its oil sands projects is now lower than $50 a barrel (due to declines in infrastructure and labor costs) – and that at a crude oil price of $50 a barrel, Suncor would still obtain a decent return on its investment.  This suggests that the recent increase in non-OPEC oil production is not a “one-trick pony.”  In fact, the EIA projects that non-OPEC oil production would increase by an additional 45,000 barrels/day in 2010, despite the lack of upstream investments and recent discoveries in Mexico, the North Sea, and Russia.

The recent build-up in US inventories of crude oil and petroleum products (which includes crude oil in the Strategic Petroleum Reserves and commercial gasoline inventories) provides another headwind for global oil prices, as shown in the following chart:

U.S. Stocks of Crude Oil and Petroleum Products, December 2007 to Present

The build-up in US oil stocks is also confirmed by the recent spike in OECD commercial oil stocks.  According to the EIA, current commercial oil inventory in the OECD countries increased from 57 days to 60 days of supply in the first quarter of 2009, or an estimated 2.734 billion barrels.  This does not include the additional 130 million barrels of crude oil in floating storage (i.e. in leased oil tankers), which is not accounted for in the following chart:

Days of Supply of OECD Commercial Oil Stocks

Finally, according to news agency Xinhua, China's crude oil inventories increased by 30% in 2008, equivalent to 34 days of supply, or 272 million barrels.  This does not include the oil reserves in the Chinese government's inventory – which is estimated to add an additional 100 million barrels to total Chinese reserves.  In the meantime, the Chinese should continue to take advantage of current prices to add to its reserves.  In fact, China has plans to increase its strategic reserves to a capacity of 280 million barrels by 2011.  Combined with the relentless push for more alternative energy sources and means of delivery (such as plug-in hybrids) across the world, the global oil market should remain challenged for the next 18 months, if not beyond.

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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 2006 to May 15, 2009) - For the week ending May 15th, the Dow Industrials declined 306.01 points, while the Dow Transports declined 298.16 points. The nine-week upside streak of the Dow Transports finally ended last week with a 9% decline. While the short-term outlook for the market remains tited towards the down side, the strength of the rally since the early March lows has been strong - suggesting that this rally has further to go. In addition, the relative strength of the Dow Transports is very encouraging, as the Dow Transports has been a leading indicator of the broader market in both the last bull market and the latest bear market. In the short-run, the most recent correction should continue, but the intermediate term uptrend remains intact. For now, we will maintain our 125% long position in our DJIA Timing System.

For the week ending May 15, 2009, the Dow Industrials declined 306.01 points while the Dow Transports declined 298.16 points.  The nine-week upside streak in the Dow Transports has finally ended with last week's 9% decline.  Encouragingly, the Dow Industrials held up relatively well, declining by only 4%.  While the market is still biased towards the downside in the short-term (medium technical indicators are still overbought), the strength of the rally since the early March lows has been strong.  Combined with improving liquidity (especially given the successful recapitalization of the US banking sector and the more dovish stance of the European Central Bank), probability suggests that the rally has further to go over the next several months.  Furthermore, recent evidence suggests that the “tail risk” of an Eastern European financial collapse is off the table, for now.  Because of this, we will maintain our 125% long position in 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 increased from a reading of -4.1% to –3.6% for the week ending May 15, 2009.   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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending May 15, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of -4.1% to -3.6%. Meanwhile, its ten-week MA (not shown) has also reversed from a historcal oversold reading of -18.9% seven weeks ago (lowest since August 2002!) to -8.9% - suggesting that sentiment has reversed from its very bearish readings and is now on a sustained uptrend. Subscribers should note that any reversal (and continuation) from historically oversold readings is usually accompanied by a significant rally. We will remain 125% long in our DJIA Timing System, and are now looking for a continuation of the rally over the next several months.

With the four-week MA reversing to the upside from a historically oversold level just a couple of months ago, probability suggests that both the rally and bullish sentiment has further to run.  Moreover, the current four-week MA reading of -3.6% is still far from an overbought reading, while the 10-week MA has just reversed from a historically oversold reading seven weeks ago.  Again – combined with the recent recapitalization of the US financial system, the elimination of the Eastern European “tail risk,” the more dovish stance of the European Central Bank, and the recent elections in India – probability suggests the rally should continue over the next several months.  For now, we will remain 125% long in our DJIA Timing System, and do not anticipate shifting back to a 100% long position until this sentiment indicator rises into overbought territory.

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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since its most recent peak on March 24th, the 20 DMA has been consolidating in the 127- to 137 range - indicating that this sentiment indicator is working off its short-term overbought conditions. While the 20 DMA has become overbought relative to its readings over the last two years, it is still oversold relative to its longer term readings. Moreover, the 50 DMA has now caught up to the 20 DMA - suggesting that this sentiment indicator has now worked off its ST overbought conditions. I believe we should see a continuation of the rally over the next several months, especially: 1) given the strong growth implications of the recent Indian election results, and 2) the European Central Bank has moved to a more dovish monetary policy.

Since its most recent peak on March 24th, the 20 DMA has been consolidating in the 127 to 137 range.  While this sentiment indicator is still somewhat overbought relative to its readings over the last two years, its recent consolidation phase has allowed it to work off its short-term overbought condition.  With this indicator still far from historically overbought levels, the ISE Sentiment reading is still supportive for a rally in the stock market over the next several months.

Conclusion: With the “tail risk” of a Eastern European financial collapse taken off the table, and with the recent successful recapitalization of the 19 largest US banks, risk premiums in all risky classes across the world should continue to come down over the next several months.  Combined with a more dovish European Central Bank and the unexpected electoral success of the reformist government in India, all indicators now point to a further rally in the stock market over the next several months.

While a global recovery this summer should be supportive for oil prices over the next several months, the fundamentals of the oil (and natural gas) markets is not conducive to a sustainable rise in oil prices over the next 18 months.  In terms of the general stock market, I continue to expect levered beta strategies to outperform for the rest of this year as global policy makers remain committed to halting the deleveraging in the financial markets.  Consequently, I expect financial stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis in 2009.  Starting in 2010, however, this trend should shift, as consumers and corporations around the world start to rebuild their balance sheets.  On a country-specific basis, I expect Taiwan to outperform as the Greater China region continue to liberalize and encourage cross-border fund flows and as the market has turned very favorable for semiconductor and technology stocks.    Whatever future growth we achieve will need to come mostly from Schumpeterian growth (I expect a new bull market in technology stocks), while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies.  With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24th.  We will sell this additional 25% long position once the market rally starts to lose steam.  For those with a long-term timeframe, the stock market is still a good buy.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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