Making sense of the oil crash

Posted by Cam Hui -

Mid-week market update: How should investors interpret the crash in oil prices and its effect on the stock market? The most simplistic way of looking at it is to observe that stock and oil prices have diverged. Either oil has to rally hard, or stocks have to fall down – a lot.
 

 

That’s a basic tactical view. While it may be useful for traders, correlation isn’t causation. These gaps in performance can take a lot longer than anyone expects to close.

It certainly isn’t the entire story.
 

A longer term view

Here is the longer term view. Crude oil and natural prices bottomed ahead of the stock market in the last two cycles, with the exception of natural gas in 2009. This is consistent with the effect of commodity prices leading stocks prices at past bottoms (see The 4 reasons why the market hasn’t see its final lows).
 

 

Credit market fallout

Warren Buffett famously said that when the tide goes out, you can see who has been swimming naked. The tide has certainly gone out for a lot of oil traders. Reuters reported that Singapore oil trader Hin Leong Trading owes $3.85 billion to banks after incurring $800 million in undisclosed losses – and this blow-up occurred before the front month WTI price fell into negative territory this week.

Monday’s negative price for the May crude oil contract was a different matter. It was attributable to a record buildup of inventory, and lack of available storage.
 

 

There was much dismissal among market participants that Monday’s negative front month oil price was a technical anomaly, and the May front month contract was thinly traded. But how thin was the May contract? The market went into the open on Monday with an open interest of about 108K contracts. The market skidded by $50 per barrel on Monday, which translates to a loss of $5 billion. To be sure, open interest fell dramatically to about 16K on Tuesday morning, but even at half that figure, that’s a very big loss and some traders would have seen enormous margin calls. Interactive Brokers reported that it is making provisions for losses of $88 million from bad debt stemming from client accounts who were long the crude oil contract that crashed.

Much attention has also been focused on the technical problems with USO. The crude oil ETP is burdened with rolling up its holdings in the front month into the next month, often at substantial cost. Notwithstanding this week’s shenanigans, the NAV of USO has continuously faced these headwinds of rolling forward futures contracts and paying the spread from one month to another. Now another oil ETF has gotten into trouble. This time in Hong Kong. The Samsung GSCI Crude Oil Trust (3175.HK) plunged -46.1% overnight.
 

 

In light of these sudden gargantuan losses, it would be no surprise to see at lease one financial blow up in the coming days. It may be a hedge fund caught off-side on a crude oil trade, a bank that over-lent to the oil patch, or a bank’s trading desk that mismanaged the crude oil hedges it sold to clients.

So far, credit markets are weak, but they show no signs of a credit catastrophe. The relative performance of high yield bonds (red line) is exhibiting a minor divergence to stocks. The relative performance of EM bonds (green line) is exhibiting a greater negative divergence, but no signs of panic. Neither is the relative performance of financial stocks (bottom panel).
 

 

Keep an eye on these indicators.
 

Broken wedges

From a tactical perspective, the S&P 500 has broken down from a rising wedge as it tested overhead resistance at its 50 dma. I interpret this as a sign of bullish exhaustion that will resolve itself with a major downleg in stock prices, or a choppy sideways consolidation.
 

 

The pattern of the broken wedge can also be seen in the DJIA, NYSE Composite, and mid-cap stocks.
 

 

The two exceptions are the NASDAQ 100, and small caps. The NASDAQ 100 had been market leaders and never formed a wedge structure. The weakness earlier this week has changed NASDAQ stocks into a rising channel, which is still constructive.
 

 

The story of the small cap Russell 2000 is different, and the performance of this index can yield some clues as to future market direction. Small caps have been weak and they were too weak to form a rising wedge structure. However, their relative performance (bottom panel) has stabilized in the last few weeks. If you squint, you can also see the hints of a bull flag. Should these stocks either stage an upside breakout through the bull flag, or show better relative performance against large caps, it would be a constructive signal that the more likely outcome is a sideways and choppy consolidation, rather than more equity market weakness.
 

 

Another indicator to keep an eye on are bond prices. Both IEF (7-10 year Treasuries) and TLT (20+ year Treasures) staged upside breakouts yesterday and pulled back. Should bond prices strengthen to break out again, it would be a bearish sign for stock prices from an inter-market analytical perspective.
 

 

Two consecutive days of falling stock prices moved short-term breadth to an oversold condition as of Tuesday night’s close. A reflex rally today was therefore no surprise.
 

 

My inner investor is still highly cautious. My inner trader remains bearishly positioned. He is keeping an open mind and monitoring how small caps and bond prices behave in the next few days.

Disclosure: Long SPXU

 

63 thoughts on “Making sense of the oil crash”

  1. In terms of commodities, have you looked at the Dec 2020 or March 2021 natural gas contracts? They’re extremely strong, any thoughts on the relative strength of the forward curve?

    1. I hesitate to make conclusions about natgas without confirmation from oil prices. NG is a regional market, whereas crude oil is a global market. So I tend to trust the oil price signal more than the natgas signal.

    2. A lot of natgas was being produced along with crude oil by frackers in Permian and other basins.

      Now as the crude oil production is expected to collapse, the supply of associated natgas will also collapse. The demand still remains robust keeping the natgas prices elevated.

  3. Poor Hin Leong. He was $300 billion in the hole before he lost another $800 million. That’s got to hurt.

  4. Cam do you have a sense of the broad timeframe when retest of lows might happen? Or possibly in for chop for the forseeable future as indicated in your post? Will follow the indicators you recommend.

    1. As I pointed out, it depends on how small caps and bonds react. If small caps continue to weaken and bond prices rally, then we are headed for another test of the lows within 2-4 weeks.

      If not, expect some sort of range-bound market and a retest later, maybe 2-4 months.

    1. thanks for sharing this link.
      How would you interpret the timeline and incorporate into the broader market (reaction/timing)?

      1. I think it is a useful link to frequently track medical breakthroughs in COVID as vaccines move through Phase I and II clinical trials and therapeutics are tested. Hope it is helpful!

  6. Horrible PMI data from Europe caused a small dip and then was followed by more buying. The market psychology of disappointing economic data causing more central bank stimulus and thus higher stock prices is deeply embedded into investor mindsets. Bad economic data means more fiscal and monetary stimulus.

    1. If the market continues to tolerate bad news well:
      – another 4.5 million jobless claims – No Prob – stimulus will cure all
      – 75% of earnings reporters can’t / won’t provide 2020 guidance – No Prob – stimulus will cure all
      – oil market a mess – uh oh – oh, just a minute – No Prob – stimulus will cure all
      – first and second quarter 2020 earnings down – No Prob – stimulus will cure all
      – probable second wave covid hit forecast – No Prob – stimulus will cure all

      Should I go with the flow and buy in? There does not seem to be too many indicators of market weakness and quite a few of market strength. Not having studied bear market bull rallies due to a non financial caused economic mess, do any of the “usual” technical indicators apply? – No Prob – stimulus will cure all

      1. It depends on whether you are trading or investing. If you are investing, your proper framework is to define how much risk you are willing to take and look through the squiggles. By defining your risk, you will have created a plan, with a target asset allocation, along with return and risk expectations. Then you vary your allocation around the target depending on your view of the market. If you are unsure, then stick with your target allocation, it won’t hurt you.

        If you are trading, then it’s a very different matter. Your time horizon and pain threshold will be different from many other people.

        1. I am essentially a retired dividend investor – all cash at the moment. With dividends being cut and earnings iffy – maybe more cuts on the way, my current plan is to do nothing but wait it out.

          On the other hand,if the worst is over (from a stock market point of view), I am missing income and spending capital – currently not a problem, but I have at least one foot in the FOMO camp.

      2. Sure seems that way…

        I’m increasingly persuaded by the Gold and Bitcoin crowd. Long SPX same trade as short fiat.

        1. Not sure about Bitcoin but my view is that gold and hard assets are going to experience a resurgence once the smoke clears. Cam, could you do a newsletter covering your intermediate/long term analysis of gold for us?

          1. Not much to say about gold. It staged an upside breakout in mid-2019 out of a multi-year base. From a long-term perspective, everything looks good and it should test resistance at 1900 eventually (don’t ask me when, I don’t know).

            Short-term, it broke out, pulled back to support and it’s rising again. Pattern looks bullish.

        2. Now there is 2 asset clasees that should have a silver dagger put through their hearts.

          Gold is a left over from ancient days and has no intrinsic value except as a non corroding metal with good electrical properties.

          Bitcoin is a figment of someones imagination and is no better than casino chips.

          If either were a “store of wealth”, then surely the prices should be reasonably static. There was a reference to tulip bulbs somewhere here. Gold and Bitcoin are no different.

          In my mind, real wealth is based on a nation’s economic activity and social well being. So called “fiat” currencies generally do a good job of reflecting national wealth. Keeping our economies strong and taking care of our citizens is the real store of wealth. In that regard, stock markets, if left reasonably unadultered, are good reflections of that store of wealth.

          Thusly, when the economies are damaged, the store of wealth lessens and the stock market should go down. If we don’t look after social well being (provide money for food and rent, health care, etc.) when economic damage occurs, then our national store of wealth can become seriously damaged. Gold and Bitcoin won’t help there.

          OK. Rant over 🙂

          2. True – except that someone else will take them as “generalised barter exchange”. If I go to my local stores, well, the ones that are open, they accept my dollars or credit card. Bitcoin and Gold not accepted there. No intrinsic value for them in that case, either.

          3. Our local stores will take gold for exchange if they came in small and convenient denominations for day-to-day transactions.

          4. A $ bill is a piece of paper with notional value. It started with Genghis Khan exchanging gold for fiat currency. Yes, oil, gold, silver, bitcoins also have notional value in a similar vein. The key difference is gold has survived millennia as a store house of wealth and medium of exchange. The mighty US $ has seen many iterations since the birth of USA by contrast.
            Another key difference is that gold cannot be manufactured (at least not yet), $ bills is another story as you know.
            Thirdly, professionals have no way to value gold as it does not have any dividend or earnings associated with it. So, a very large body of professional investors are against gold (= short gold). This is precisely the reason to own gold. See my previous messages about being long real estate last decade, before 2008. Every Tom, Dick, Harry and their dogs were long real estate before 2008. That was the time to short real estate. Using the same analogy, every professional investor, every central bank is very short gold and very very long on fiat currencies! I will let you make your own judgement.

      3. Look at the negotiations about the European stiumulus package, it was rumoured to be 1 trillion last week, then Spain came out saying it should be 1.5 trillion, now it is at 2 trillion. Neither politicians nor central bankers want to be held accountable for not doing enough. All the world leaders have been slow in their reaction to the outbreak and now want to make up for it with excessive spending. Next in line is China announcing their “bazooka” stimulus package, they have no other choice.

  7. The BIG NEWS today. The Daily Beast is reporting that Kim Jung Un is dead. His sister has taken charge of the country. Watch out for a military coup.

    1. Not seeing it or anything else…

      If nuclear war breaks out, stocks will soar, lol… Sorry, bad mood today. There’s nothing real to reality.

        1. The truest post here today, Joyce. 20 million initial jobless claims in a month, the economy has ground to a halt, earning are diving and the stock market goes up 800 points in two day. What else could it be if not the stimulus and the Fed?

      2. That’s all the world needs is nuclear war now. At least nukes will kill the coronavirus – maybe.

  8. The market seems to have hit trendline resistance (daily SPX chart) – the bears are still alive if we close below 2850. Digitimes will be reporting tomorrow that “VCM (voice coil motor) components for use in camera modules for Apple’s iPhones are likely to see a dramatic slowdown around the middle or the latter half of the second quarter, according to industry sources”

  9. Netflix secures its lowest-cost debt after ECB boost
    https://www.ft.com/content/f67a1222-a7aa-4a1c-bbae-a6407cc84eb6

    This article sums up what is wrong with the current system and why the market keeps going up as long as the credit markets are healthy. Whatever happens to the economy, companies who are believed to have a sustainable or sometime-in-the-future-profitable can simply tap the credit markets. For investors corporate bonds are virtually risk-free because the Fed will always bail them out.

  11. $350 B more from Congress for small business and hospitals. Is this going to find its way into the market? Of course, the Fed is pumping that much money into the economy every 7 days.

  13. Boston Consulting Group’s investory survey offers some insight:
    https://www.bcg.com/publications/2020/covid-investor-pulse-survey/second-edition.aspx

    60% of investors are bearish for the remainder of 2020 and expect a low point of ~2158 vy the end of June 2020
    53% are bullish for 2021 and 64% are bullish for 2022 with an expected S&P 500 level of ~3165

    88% do not expect a V-shaped recovery and 15% of investors expect the S&P 500 to return to earnings growth by the end of Q3 2020

    Preserving liquidity and building key business capabilities is much higher on investors whish list than delivering EPS that meets guidance.

    1. This certainly explains the teflon like resistance to bad news!!

      I still read surveys like this with a sense of disbelief. Either I don’t understand (more than likely) and this disease is much less risky than I think, or a blind sense of optimism has grasped the US investment community. Or the disease has become very politicized.

      If you are on the GOP side of the fence (and have more money) you go with the White House daily briefings (all will be fine, no second wave, etc. etc).

      If you see the world more like the majority of the state governors, this pandemic will be much longer in resolution and may well cause greater damage bot socially and economically if not treated with great care, and even then, all may not go as well as we would all like.

      The outcome from states like Georgia reopening might change opinions if case counts start to rise and the “second” wave possibility takes hold.

      2. Whose consensus, Alex? The medical community seems to think there could well be a second wave, but the White House is not sending that message – quite the opposite, I think.

        To quote DJT:
        The president also downplayed the danger of the virus returning in the fall at the briefing, saying, “We may not even have corona coming back.” And if it did, he said, it would just be in “pockets” and “embers.”

        No evidence presented to support this claim.

        Also suggestions made like:
        US President Donald Trump has been lambasted by the medical community after suggesting research into whether corona-virus might be treated by injecting disinfectant into the body.

        This has caused disinfectant companies to issue serious warnings about not doing this.

        All of these kinds of comments are so damaging to peoples perspective on the seriousness of this pandemic. Remember the remdesivir mess and the hydroxychloroquine push. There is much disinformation and very low consensus, that I can see, in the US right now.

      3. “Or the disease has become very politicized.”

        Uh huh… which implies? Simple thinking, two choices. Open the economy… 1,2 5% deaths? Whatever. Couldn’t be prevented, foreseen, etc. Excuses and lies. But stocks are UP! Versus, save every life, no matter the cost (PS: to you not me, hahaha).

        We are ruled by high functioning sociopaths. Truth is, just letting COVID burn through the US population unmitigated is best for the 1% types who can afford protection and position for the rebound. We have too many low skill workers anyway. And can always get more of those.

  14. Singapore recently extended lockdown for another 4 weeks. Read that they did well in testing and contact tracing, but failed miserably like most nations in implementing social distancing and mask usage. Tests without mask/social distancing doesn’t work. Taiwan seems to be one of the most if not the most successful in handling cov19. Wondering how their approach affects their economy and if it’s applicable to other nations.

  15. Any idea if the Fed extending intraday credit to banks will effect equity markets? from: https://www.federalreserve.gov/newsevents/pressreleases/other20200423a.htm

    (1) suspending uncollateralized intraday credit limits (net debit caps) and is waiving overdraft fees for institutions that are eligible for the primary credit program; and (2) permitting a streamlined procedure for secondary credit institutions to request collateralized intraday credit (max caps). Relatedly, the Board is suspending two collections of information that are used to calculate net debit caps. The Board believes that these actions will not meaningfully increase credit risk to Reserve Banks. These temporary actions will be applied immediately and will remain in effect until September 30, 2020, unless the Board communicates otherwise prior to that date.

    1. Probably not much immediate effect. There were no takers for their last repo facility.

  16. I think this is a news driven market with just 3 sources of news that can effect the market. The three sources that can move the market are news about 1) The Fed, 2) Government Stimulus and 3) CoronaVirus or Cures. News from the Fed or the Government bailouts will all be bullish. News about the CoronaVirus or Cures can be bullish or bearish. Given no news about these, the market works its way up as time passes.

    So, we have 2 1/2 news sources that can make the market go up and 1/2 news source that can make it go down.

    Seems like a bullish preponderance of the odds to me.

  17. The April 2020 SPX rally, I believe, has been largely misunderstood. Investors are apparently bullish on 2021/22 and have bid up stocks before earnings season in order to listen to the message from wall street CEOs. The message is that CEOs think that 2020 will be a disaster but they are not changing their optimistic outlook for 2021/22.

    1. That sounds about right, but here is a cautionary message from Greg Ip at the WSJ:

      The lockdowns and the fiscal and monetary backstops have eliminated the worst-case scenarios “for hospitalizations, mortalities, and bankruptcy filings,” but not the baseline scenario “which involves a massive negative shock to national income,” said Mr. Thomas. This doesn’t seem consistent with S&P 500 index hovering just 15% below its pre-pandemic high.

  18. Can you differentiate ( for today and the week) the buying of retail investors vs institutional mutual fund buyers? If so, who is buying more and by what percentage?

    1. Good read.

      Re Wachter’s Grand Rounds I’ve only had time to listen to the first lecture by George Rutherford – the epidemiology guy. His Q&A was instructive.

      (a) A second wave is not inevitable – however, he puts the odds of NOT having a second wave at 10% to 20%.

      (b) In the absence of a vaccine, how do epidemics end – the Spanish Flu for instance? ‘It exhausted the supply of the susceptibles.’ Herd immunity, in other words – which occurred only after 50%+ of the world’s population had caught the flu.

      (c) Passports that indicate one is antibody-positive? Not all antibodies are neutralizing antibodies. Some percentage of the population will not be immune despite testing positive for antibodies.

      (d) Patients that retest positive following recovery? Probably the result of intermittent shedding of viral particles (even toilet seats will retain particles for 6-7 weeks).

      1. There were a lot more rural families and not so much travel and close contact with strangers and a more spread out population in the U.S particularly back in the days of the Spanish Flu.

        Today we live a lot closer together. I’ve noticed a huge difference in the ‘in your face’ population just since I was a kid.

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