Natural Gas and 3Q 2011 Household Debt Payments
(December 18, 2011)
Dear Subscribers and Readers,
Let's begin our commentary on the Fed's latest Flow of Funds data with a review of our 13 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;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;
12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;
13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.
Natural gas has been one of the most discussed commodities throughout our commentaries. We first discussed natural gas in our July 31, 2005 commentary (“Natural Gas – The Other Bull?”) when we became bullish on it because of its positive correlation with crude oil (at the time, “fuel-switching” for industrial companies still impacted the relationship between fuel oil and natural gas prices); and because of ongoing domestic demand growth. Natural gas prices actually rose after our report—subsequently peaking at over $15/MMBtu that winter (mid-December 2005)! The idea of shale gas being a significant part of the supply structure was nowhere near on a radar screen at that time (confirming the Yogi Berra quote “It's tough to make predictions, especially about the future”). As alluded to in the classic Chinese text, the “Classic of Changes,” the only certainty is change.
Unbelievably, the Henry Hub (based in Louisiana) spot price is now just over $3/MMBtu—something inconceivable in 2005! More important (at least for John Arnold and other natural gas traders), the volatility of natural gas—which peaked at more than 3x that of WTI crude oil—has died down. This is not surprising in light of the immense shale gas supply. What has been less covered is the increase in natural gas storage levels—not just current working gas but total storage gas levels.
As shown in the above chart (courtesy of the U.S. EIA), working gas natural gas storage levels (at 3,729 bcf) are now sitting at the high-end of its five-year range—154 Bcf (billion cubic feet) higher than last year and 347 Bcf higher than the five-year average of 3,382 Bcf. This extremely high working gas storage level has two direct effects: 1) reduce the absolute price of the commodity; and 2) reduce its volatility—as a colder-than-expected weather would no longer fuel the fears of a natural gas shortage. This is important, as the 2005 winter spike in natural gas prices was partially due to the fears behind an actual shortage of natural gas (further fueled by speculation by natural gas traders). Indeed, as shown in the below chart, the total natural gas storage level in the U.S. has risen by 500 Bcf since our commentary in 2005. While 500 Bcf makes up only 6% of total storage levels, an increase of 500 Bcf in working gas levels is sufficient to dampen volatility significantly, as current demand—even during a colder-than-expected weather—is not enough to trigger fears of a natural gas shortage.
In other words, the trading paradigm in natural gas has changed, as any natural gas trader could have told you over the last several years. Going forward, both the domestic natural gas price and volatility will likely remain low (UNG traders please remain cautious!). While there has been less drilling activity in the Haynesville Shale, activity in the Marcellus Share has been ramping up. Until the U.S. starts exporting LNG or until we adopt more electric vehicles on our roads (coupled with the construction of more natural gas fired power plants), natural gas prices and volatility will remain low for the foreseeable future (next couple of years at the very least). Yes, we are definitely not going long UNG just yet.
Let us now discuss one of our long-term themes—that of deleveraging in U.S. households. We discussed this in our recent commentary from a U.S. balance sheet standpoint (“Greece and 2011 3Q Flow of Funds Update (Housing Still Needs Attention)”). Similar to our previous commentaries on the Fed's Flow of Funds, we argued that more deleveraging was needed—preferably until U.S. households' asset-to-liability ratio rises to 5.50 or higher, and that the Fed will not tighten monetary policy until that occurs. While we don't know whether it's voluntary or forced (likely a bit of both), the fact of the matter is that U.S. households are saving more, spending less, and paying out less interest payments as a percentage of their disposable income. On a disposable income basis, however, the deleveraging process is further into the game—although this has more to do with lower interest rates. From this perspective, the trend of deleveraging U.S. households is evident in the declining proportion of U.S. disposable income dedicated to debt payments. As I mentioned, US households' balance sheets will continue to deleverage (as consumers adopt a more frugal lifestyle; and as banks and credit card companies restrict lending). Sometime over the next several years, the inevitability of Schumpeterian growth (as well as old-fashioned population growth) will allow U.S. economic growth to normalize again. The combination of this Schumpeterian growth and relatively clean U.S. household balance sheets will drive the next secular bull market in U.S. stocks. While the ongoing deleveraging isn't as clear in the 3Q 2011 Flow of Funds data, there is obvious evidence that U.S. households are saving and paying down their debts. This is clear in the most recent trends in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
The financial obligation ratio for all U.S. Households' declined to 16.15% during 2Q 2011 (its lowest level since 4Q 1993!), and has remained steady during 3Q 2011. Note that one reason may be that many households simply stopped paying their debts. Despite these benign numbers, the deleveraging in the broader US economy should continue, although we have likely finished the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults (although I expect U.S. housing prices to remain in the doldrums for years to come). Furthermore, as U.S. households pay down more of their debts and become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the U.S. economy and society. The “Black Swan” risks remain in Europe, where there will likely be a substantial “regime” change (e.g. a restructuring of the entitlement system, Greece leaving the Euro, etc.) over the next 3 to 12 months.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:
For the week ending December 16, 2011, the Dow Industrials declined 317.87 points, while the Dow Transports declined 50.76 points. Despite last week's decline, the Dow Industrials is still up by 8.6% since the end of 3Q, and is therefore still in slightly overbought territory. Combined with the ongoing problems in the Euro Zone, the succession jitters in North Korea, and the weakness in our liquidity indicators, we believe the market could undergo a further correction. As such, we will remain neutral 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 four-week moving average of these sentiment indicators decreased from 5.4% to 4.5% for the week ending December 16, 2011. 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 2001 to the present:
Since hitting a multi-year low of -11.3% just over two months ago, the four-week MA has risen 15.8%--and is slightly overbought in the short-run. Given our weakening technical indicators, the ongoing European Sovereign Debt Crisis and the jitters over the North Korean succession plan, we will remain cautious until the four-week MA hits oversold territory again. Again, we are anticipating a correction into the end of this year.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. 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. 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:
The 20 DMA finally broke out of its four-week range of 91 to 99 during the week prior, and is now above 100 for the first time since November 4th. Moreover, it remains above its 50 DMA. Such a breakout from a highly oversold condition is usually bullish, but given the potential “Black Swan” events emanating from the European Sovereign Debt Crisis (even though our overall liquidity indicators have improved given the creation of the bilateral US$ swap lines), we will remain neutral in our DJIA Timing System.
Conclusion: The natural gas regime has changed, as evident by falling gas prices and volatility over the last several years. Given the domestic supply glut and ample storage levels, I do not see any fundamental reasons for turning bullish on the commodity in the near future (keep in mind that the “rolling costs” of purchasing UNG are extremely high), unless LNG exports are ramped up (international natural gas prices are much higher). In the meantime, I expect the market to correct going into Christmas. Aside from the ongoing European jitters, the lack of fear in the market (as indicated by the relatively low VIX) is worrying from a bullish standpoint. We remain neutral in our DJIA Timing System; and will take a wait-and-see approach. Subscribers please stay tuned.
Henry To, CFA, CAIA