While we were all sitting around rubbing our bellies last Friday, the financial world not so quietly turned meaningfully. Energy and the commodities complex may have just experienced a washout event in the short term. Several other sectors are running into price pattern trouble and the stock market in general has again moved back into the high-risk zone based on a number of important metrics. This is not a time to get complacent despite the happy season.
Energy and Commodities
Friday was perhaps one of the ugliest single days I have seen for commodities, including gold and silver, as well as anything that even smelled of fossil fuel. Losses in single stock names were in the double digits, diversified energy funds lost between 6-8%, and commodities funds were down 4-6%. Wow! Now of course any self respecting investor would have been long gone from these sectors as price trends clearly fell apart five months ago. There are several important truths and lessons to be learned from what is happening in the energy world specifically.
In terms of truths, we can be sure that OPEC nations in the Middle East will win this game of chicken with our domestic energy producers. They will happily wait us out knowing that we cannot operate profitably at much lower price levels. Domestic oil and gas production costs are 3-4 times that of the Middle East by the nature of access and availability. Furthermore, the quality of US oil and gas is lower making it more expensive to refine into usable fuel. “Drill baby Drill” mentality has driven our domestic production levels to the absurd leaving the world with a glut of supply while our costs of production continue to rise year over year. Other truths – the price of gas at the pump will not track the price of oil as much as you might hope. Refining capacity is the issue and a key element determining supply and price of gasoline in distribution. Here we have a bottleneck as the US has not expanded our refining capacity in years. Oil prices have fallen from the highs by 34% through last Friday. Gas prices have fallen only 15% in my neck of the woods ($3.68 to $3.12). We have an ugly situation for the energy companies which is starting to look a lot like the gold bust days in the 1800’s. Finally, we also know that energy stock prices have retreated dramatically and may be carving out a very volatile bottom at least until the next round of earnings. Every energy analysis in the world is crying FIRE so expectations are already very low. We’ll see if actual earnings are better or worse early in 2015. Bottom fishing is a possibility now but only in your highly risk tolerant accounts.
On the lesson front, we are seeing what happens to a sector or an asset class in the aftermath of years of price manipulation. Oil prices have had the luxury of OPEC to regulate them with supply side controls. When prices are too low, OPEC would cut production, when too high, they would increase production. Now OPEC has formally announced that the West has made their own bed by allowing unbridled production and extraction. We have run amuck in our frenzy to make a buck assuming prices would always remain somewhat stable. Obviously that is no longer the case. Now that OPEC has removed itself as a quasi-regulator of supply or buyer of last resort, we see what happens; the market quickly and violently finds a “market” price based on actual supply and demand. Now think about what other asset classes have been heavily manipulated. How about bonds and interest rates? How about Sovereign currency markets? We should all be potentially ready for some violent repricing in interest rates once our central bankers in Europe, Japan or the Federal Reserve make the same choices as OPEC. There is too much supply of low value Sovereign debt and paper currency in the world financial system just as there is currently too much supply of oil and gas in the world.
Last week, I spoke at length about selection. Selection analysis and criteria are one of our important risk management tools keeping our clients invested in things that go up and out of things that go down with focus on market leadership. Back in July several sectors and asset classes peaked and began corrections, which have yet to reverse to the upside. These are energy, commodities, metals, basic materials, precious metals, Europe, emerging markets, high yield bonds and all small caps. Everything else has really pushed out to new highs after the steep market correction in mid October. Some areas have pushed out stronger than others. Clear leadership still exists in large cap value, healthcare, biotech, pharmaceuticals, utilities and consumer staples (note – all defensive sectors) while we have seen only marginal leadership in financials, technology and banking (note- all growth sectors). In the last few sessions, we have seen an early breakdown in banking and possibly technology. As a market moves closer to a more meaningful top ahead of a protracted bear market, we often see sector drop outs and I’m especially aware that this might be happening now. Today we sold our long-standing bank sector funds to cash and have several other sells ready if necessary.
Market Indicators Flashing High Risk Again
Coincidentally, last week we saw several of our critical market metrics move again to a high risk zone. Some of these metrics are subjective like sentiment figures; others are more empirical like valuations and money flow. At the bottom in October, I made a list of all the good stuff I saw from a short-term technical perspective. The list was long giving us some great reasons to add exposure to our strategies and get reinvested after cutting exposure since July. Now, if I were to make another list, it would be stacked with bearish indicators. In fact, Jason Goepfert of Sentimenttrader.com actually quantifies the number of technical indicators at both bullish and bearish extremes. This morning, I count 26 at extremes that are bearish for stocks looking forward and only 6 in the bullish camp. This doesn’t mean that prices can’t go higher but simply that the odds of December meeting the up, up and away expectations are suddenly not very good.
These indicators, while mostly short term, do influence our net exposure model discussed last week. From a longer term perspective, I am increasingly concerned about valuations, which have moved to the same levels as 2000 and 2007 or in some cases higher. Most valuation models suggest the seven year (yes the next seven years!) average annual returns for stocks will be at best around 2% until we get a deep stock market correction. All things considered, given the deteriorating technical conditions and the fact that we may be losing more sectors incrementally, we are selling as needed and keeping proceeds in cash for now as we purposely reduce our net exposure. We are not smart enough to know that day when to sell all but our system will have us defensively positioned as daily conditions warrant. If you don’t have a sell side system or discipline beyond gut and watching your account balance, please call us.
That’s it for this week – sorry for the gloom during this festive season.
But do make it a great week!