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Dissecting the Intermediate Term Trend

(September 10, 2009)

Dear Subscribers and Readers,

The EIA's monthly Short-Term Energy Outlook has just been published.  While EIA's 12-month price forecasts for crude oil and natural gas are typically wide off the market, these monthly reports do yield some important facts, namely demand/supply dynamics, current and short-term projections of crude oil and natural gas inventory levels, as well as a summary of the market action during the prior month.  One example is the EIA's take on U.S. natural gas production – specifically why production has held up in the face of a crashing rig count – an “anomaly” which we first discussed a couple of weeks ago.  Quoting the EIA:

Despite a 20-percent drop in prices and a 45-percent drop in working natural gas drilling rigs since the start of the year, total natural gas production increased slightly from January to June 2009.  This current production trend reflects significant improvements in horizontal drilling technology and robust productivity from shale gas discoveries in Louisiana, Oklahoma, Arkansas, and Pennsylvania.  While lower prices have caused a reduction in drilling activity by all rig types, according to data compiled by Smith International, working horizontal rigs have fallen by only 27 percent since the start of the year compared with a 65-percent decrease among vertically-directed rigs.  Working horizontal drilling rigs now represent more than half of the active natural gas drilling fleet.

Despite the reduction in rig counts, the increased efficiencies in horizontal drilling have greatly increased natural gas production.  While the EIA expects production to eventually decline later this year, part of this decline will be offset by increased production from the Gulf of Mexico due to continued recovery from the damage incurred in last year's hurricane season.  In addition, LNG imports should continue to increase for the rest of this year as new LNG supply facilities come online.  As a result, the EIA expects working natural gas inventories to reach 3,840 Bcf by the end of this injection season, or October 31st (assuming a weekly injection average of about 57 Bcf over the next nine weeks).  This is 275 Bcf above the previous record high of 3,565 Bcf reported at the end of October 2007, or just 60 Bcf below the total US storage capacity of 3,900 Bcf (as estimated by the EIA).

U.S. Working Natural Gas in Storage

As natural gas storage capacity starts to run out over the next several weeks, natural gas producers will begin to curtail their production.  In the meantime, natural gas producers are still producing as much gas as possible, as virtually all their production are hedged at higher prices and as there is no individual incentive to curtail production (even though on a collective basis, curtailing production right now makes perfect sense).  Once storage capacity runs out, we could witness a tremendous decline in natural gas spot prices all across the US and Canada as producers dump their gas on the markets at whatever price they could sell.  The sheer size of the natural gas ETF, UNG (which currently holds over 50% of the open interest in the October NYMEX contracts), as well as the contango between the spot price, the October and the November contracts make UNG a very unattractive ETF for those who want to gain long exposure to natural gas.  In fact, I would not be surprised to see UNG decline an additional 30% to 40% from current levels over the next 45 to 60 days.

Dissecting the Intermediate Term Trend of the Stock Market

As we mentioned over the last couple of weeks, we believe that while a correction during September is probable, we also believe that the intermediate term trend of the US stock market remains up.  A major reason for our belief has been the impressive upside volume and upside breadth since the early March lows.  Combined with the unprecedented liquidity provisions of the world's central banks, the immense capitulation and a 27-year low in the price-to-book ratio in the S&P 500 during the early March lows, we asserted that a cyclical bull market began at that time.  Therefore – just like all prior cyclical bull markets – the end will only come once there is “exhaustion” among equity investors, and based on our indicators, we are still not close to that.

One major indicator suggesting that the intermediate upside trend remain intact is the strength in the NYSE Common Stock Only Advance-Decline Line.  Traders believe that cap-weighted indices such as the NASDAQ Composite or the S&P 500 cannot have a sustained advance if they rise without the A/D line confirming (commonly called a “divergence”).  There have been various times in history when the A/D line has acted as a precursor of a significant stock market top, such as the topping out of the NYSE A/D line in April 1998  – nearly a whole two years before a corresponding peak of one of the greatest bull markets in modern history. As shown in the following chart (courtesy of, the NYSE CSO A/D line has continued to make new highs in recent days, suggesting that the intermediate upside trend remains intact:

NYSE Common Stock Only Advance-Decline Lines (6-Mo)

In addition, the amount of cash sitting on the sidelines – as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap – is still at a relatively high level, as shown in the following chart:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to August 2009) - At its peak at the end of February 2009, this ratio spiked to a 27-year high 65.95%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to 45.40%. While it is only at a slightly lower level as the highs set in the bottom of the previous bear markets in the late 1980s and late 1990, the ratio has definitely come down too far, too fast. This author is thus looking for a short-term correction in the stock market for the foreseeable future, although the long-term uptrend remains intact.

However, as we have mentioned previously, the U.S. stock market remains very vulnerable to a correction over the next several weeks.  One major reason has been the great loss in upside momentum over the last couple of weeks.  As measured by the recent action in Lowry's Buying Power Index vs. Lowry's Selling Pressure Index, investors in US stocks have gotten increasingly reluctant to buy more stocks (and more eager to sell) during the latest recovery from the 90% downside day on August 31st, versus the recovery from the 90% downside day on August 17th.   In addition, the Shanghai Stock Exchange (SSE) Composite Index – which has been a leading indicator of global equities and economic growth since early 2008, has continued to languish below its most recent peak in late July, as shown in the following chart (courtesy of

Shanghai Stock Exchange Composite Index (EOD)($SSEC)

Finally, the Dow Jones STOXX Europe Bank Index (representing large, mid, and small cap banks across 18 countries of the European region) also made a short-term peak in late August (as shown in below chart).  The action of this index is important as we continue to believe that there are still risks within the European banking system that could pose a risk to the global financial system in the short to intermediate term. 

Dow Jones STOXX Europe Bank Index

Going forward, the action of this index will tell us whether investors are starting to take into account the potential balance sheet problems within the European banking system.  In other words, this index could very possibly act as a leading indicator of global equities – and if so, then it is likely that the US stock market will endure a short-term correction over the next several weeks, even though the intermediate term uptrend remains intact.

Signing off,

Henry To, CFA

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