Tuesday, April 19, 2016

What a long strange road it's been...

I thought I'd take a moment to revisit what has transpired in the global markets over the past two months because it really has been unprecedented.



Back in mid-February the global markets were sitting on a razor's edge.  From a technical perspective if stocks fell another 1% they looked like they might fall 50%.  This technical backdrop was coupled with a fundamental picture that was deteriorating across the globe.  China, technology, oil, energy, pharma, everything was (maybe is??) entering a slowdown at the same time.  This had all of the hallmarks of a major 2008/2009 meltdown lining up again.

And then just as it seemed the stars had aligned something changed almost overnight.  The key catalyst that started the market's historic surge from February (up 14% in 2 months - roughly an 85% annualized rate of return) was the bounce in crude oil prices.

If you remember in February we were starting to see the first signs of retail gasoline prices cracking the $2.00 mark.  West Texas crude oil was hovering around $31/ barrel and the outlook was grim.  The world is awash in oil right now and central bank policies have encouraged many countries and companies to expand capacity beyond what the market can bear.  These companies and countries  need to keeps pumping oil to make their debt payments but this supply issue is coupled with another major problem -- the growth in demand for oil is falling right now.  Okay, so in a logical world you would say - supply is growing, demand is falling the price of this product should continue to decline.  However, we no longer operate in a world dictated by logic.

The oil markets are now heavily influenced by the same electronic trading platforms that have made a mockery of our stock markets.  These trading bots, for lack of a better term, are scanning every headline for a hint on the direction of crude oil.  Conveniently, at the moment when oil prices and the US stock market were on a razor's edge word began circulating that OPEC was going hold a meeting to discuss a production freeze in April.

The problems with this concept are many -

1) OPEC members are notorious cheats.  They say they will only produce X, yet they will produce x+10%.

2) OPEC's influence is waning in light of US/Canadian/Russian production.

3) You have to get parties that don't particularly like one another (Iraq, Iran, UAE, Saudi Arabia) to agree to terms.

However, the rumor of a meeting set off a buying frenzy in the oil markets which ultimately spread to other commodity classes (Why? No one knows, why ask questions, just BUY!!!).  This is an oversimplification but there are many stock programs that see the world through a simple lens of "if/then" relationships.

Since, oil prices were up that must mean demand was going up, right?

And if demand is going up, that means the global economy is picking up steam and that must mean stocks are set to rebound so....

BUY EVERYTHING!!!!

Now, there have been other catalysts that have played a role - the Fed's unclear messaging, Japan's panic move to negative interest rates, etc - but the most significant and consistent driver of the oil and stock markets has been this idea that oil prices were going higher.

Every day brought a new rumor - "Russia says......", "Iran says......." "Saudi minister says......" and every headline brought more buyers.  Then a funny thing happened - they met this weekend and the result was no agreement on production.

Wait, WHAT!?!?! So, the 15% bounce in stocks and the 30% bounce in oil prices that were all driven by the premise of a major agreement on reducing supply has been a fraud?  Obviously, this means oil prices and stock prices are set to plummet, right?

Again, we are trying to apply logic to an illogical world.  Yes, the immediate reaction by the humans in the market was to sell both oil and stocks (oil slipped 5% and some global markets were off 3% immediately) but as the programs started kicking in around 9:45 am yesterday it was clear that this was not your father's market.  Stocks and oil prices ripped higher for the rest of the day until the Dow managed to end above 18,000 for the first time in 9 months.

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So, that's the back story of the past 2 months, but let's consider what is going on in the US right now.

* Q1 GDP estimates are around 0.3% to 0.5% growth.  That's a round error away from being in contraction.  Seven years into the "recovery" the US is growing at about 1/10th of what would be considered healthy.

Well, you might say Q1 2014 and Q1 2015 were weak as well - true, but remember we blamed that weakness on a polar vortex and East Coast blizzards.  Who can we blame for this weakness in the wake of the warmest winter in 20 years?

*Freight shipments are weak and trailing even weak first quarters like 2015 and 2014.

* Look at some of the early results from huge US companies - IBM, Morgan Stanley, Goldman Sachs - the disconnect between these results and a stock market that is within a whisper of its all-time high is strange.

* I continue to believe that the real price of oil given the current supply/demand picture should be around $25/barrel.  When evaluating a forecast like that you have to ask yourself are you a bigger believer in the power of market fundamentals or Central Bankers?  The Central Banks have had a much more significant role over the past 7 years but over the past 100 years I'd say that fundamentals tend to win out.

To summarize - I'm feeling a little like Don Quixote at the moment because I know certain things to be true but the markets are telling me that what I know is wrong every single day.  Eventually, that may change but until then I'll be out tilting at windmills.

Cheers!

PS - I wrote this late at night and my spell check isn't working so please excuse any errors :)