• 287 days Will The ECB Continue To Hike Rates?
  • 288 days Forbes: Aramco Remains Largest Company In The Middle East
  • 289 days Caltech Scientists Succesfully Beam Back Solar Power From Space
  • 689 days Could Crypto Overtake Traditional Investment?
  • 694 days Americans Still Quitting Jobs At Record Pace
  • 696 days FinTech Startups Tapping VC Money for ‘Immigrant Banking’
  • 699 days Is The Dollar Too Strong?
  • 699 days Big Tech Disappoints Investors on Earnings Calls
  • 700 days Fear And Celebration On Twitter as Musk Takes The Reins
  • 702 days China Is Quietly Trying To Distance Itself From Russia
  • 702 days Tech and Internet Giants’ Earnings In Focus After Netflix’s Stinker
  • 706 days Crypto Investors Won Big In 2021
  • 706 days The ‘Metaverse’ Economy Could be Worth $13 Trillion By 2030
  • 707 days Food Prices Are Skyrocketing As Putin’s War Persists
  • 709 days Pentagon Resignations Illustrate Our ‘Commercial’ Defense Dilemma
  • 710 days US Banks Shrug off Nearly $15 Billion In Russian Write-Offs
  • 713 days Cannabis Stocks in Holding Pattern Despite Positive Momentum
  • 714 days Is Musk A Bastion Of Free Speech Or Will His Absolutist Stance Backfire?
  • 714 days Two ETFs That Could Hedge Against Extreme Market Volatility
  • 716 days Are NFTs About To Take Over Gaming?
The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

Modern monetary theory has been…

Trade In Counterfeit Goods Hits Half A Trillion Dollars

Trade In Counterfeit Goods Hits Half A Trillion Dollars

The counterfeit market has breached…

  1. Home
  2. Markets
  3. Other

the Crude Reality in Oil

OIl Well

Just as we've found the more contemporary comparisons of previous rate tightening cycles misleading with today (e.g. ZIRP), we find a similar fallacy in gleaning a positive context of the relative health of the US equity markets after a significant decline in commodities. Point being, with the bottom falling out of oil over the past few weeks, some analysts have pointed to periods in the 1980's and 1990's where equities continued to outperform, subsequent to major corrections in oil. While we would agree that the recent decline in oil is less a statement on the health of the US economy and primarily a market driven consequence of a zero sum game, we do view the extreme nature of the move as another hallmark of exhaustion in the broader downtrend in commodities - than one of continuation that many participants appear to gravitate towards.

This isn't surprising given the dominance of trend in the equity markets over the past four years, where participants have been shaken out of their initial intuitions of more inflationary driven investment theses, into a concerted reach for yield in the equity markets. That said, we believe there is a valuation ceiling - either rational or not, that the equity markets have been pushing up against over the past year and which we expect is limited by the markets disposition in the trough of the long-term yield cycle (see below). While the Fed has succeeded in raising the valuation ceiling in equities far above where almost everyone had anticipated six years ago, participants would be exceedingly optimistic to expect that the markets and the economy could carry a significant and sustained rise in yields that would accompany a move out of the long-term yield cycle's trough - and away from the cyclical nature in the markets we still believe exists between equities and commodities today.

CAPE (Annual) and 10 Yr Yield (Annual)
Larger Image

Although the economic data has continued to come up roses, just as the housing market quickly took a significant hit when yields surged in 2013, we think the collective knock-on effects to the economy can not be overstated when considering a rising yield environment. Historically speaking, this is why the trough of the cycle is so long and shallow, as the markets and the economy slowly transition to be capable of carrying the heavier yield weight of the next growth phase. When we look at the size of downtrend in yields over the past four decades and the benevolence it imparted to assets such as equities, it seems reasonable to expect that the trough of this cycle would at least be commensurate with the scope of the previous (1940's) - with the real possibility of greater asymmetries extending the low yield environment even longer than its mirror. For market participants, this is akin to working in geologic time and one we expect could unfurl with similarities to the mirror of the cycle in the 1940's - as equities and commodities rotate between cyclical moves across the trough with more or less a sustained bid in the Treasury market.

10-Year Treasury Yield (Annual) and 3-Month Treasury Yield (Monthly) and PPI
Larger Image

10 Year Treasury Yield (Monthly) and 3 Month Treasury Yield (Monthly) and Core PCE
Larger Image

Appropriate pace of policy firming. Midpoint of target rane or target level for the federal funds rate
Larger Image

Over the past week the talk of the Street has been whether the Fed would remove "considerable time" from its policy statement at this weeks meeting. The general consensus appears split between leaving the language as is or amending the statement to reflect a modest shift to an increasingly data dependent posture. All things considered, we believe either outcome is a moot point over the next several months, as the inflation data will likely be weak as the lagged effect from the strong dollar and commodity slump makes its way through the system - further easing expectations of more imminent rate hikes by the Fed next year. We think the best case scenario would eventually reflect an excessively modest and gradual rise in the fed funds rate, as we know the 1937 rate hike from the trough looms large within the Fed as well as the broader collateral impact to world markets. Either way, we find the FOMC members own dot plot projections, wildly optimistic of where the funds rate will be at the end of next year and thereafter. For now, this expectation gap should provide further downside in yields as the market continues to pan Treasuries with expectations of a rising rate environment in the back half of 2015.

10 Year Treasury Yield 2008-Today and 10 Year Treasury Yield 1934-1947
Larger Image

While we expect the inflation data over the next few months to reflect the significant move in the dollar since this summer, the reversal in gold last month may be a leading indication that the dollar - like the equity markets, are butting up against the limits of their respective trends.

Equity Markets Chart
Larger Image

Historically speaking, the same leading nature in gold has been present in the past with upside reversals in oil.

GOLD and OIL (WTI)
Larger Image

As measured by its weekly RSI, oil is the most oversold it has been in over thirty years. The other two RSI extremes were in 2008 and in 1986.

Oil (WTI) Weekly
Larger Image

To illustrate and contrast these three comparative declines, we created two studies. The first was normalized to momentum and performance and the later to duration and performance. The broad brush takeaways would indicate that in the two previous occasions where the market expressed its most oversold condition, oil subsequently stabilized with a retracement rally - before completing the downtrend. In both previous occasions, the moves were approximately 90 percent complete with respect to downside performance and approximately 85 percent complete for the duration of the decline.

Oil Chart
Larger Image

Oil Chart
Larger Image

Although we've been following throughout the year the relative symmetry in the pattern of the SPX:Oil ratio, we did not anticipate another decline to develop in oil along the lines of the mirrored shoulder that was formed in late 1985 into 1986. Hindsight 20/20, this appears as a rather daft read - but par for the course of play this year as nasty curveballs were once again thrown in commodities and currencies in the back half of the year.

SPX:OIL Ratio (WTI weekly)
Larger Image

What's interesting to note, is that assuming the decline in oil is close to exhaustion, when we look at the pinnacle of the ratio with the major low set at the end of 1998 in oil - the pattern symmetry, structure, seasonality and performance are quite similar with that periods capitulation decline.

Oil - similarities between 1998/1999 and current
Larger Image

WTI 1998/1999 and WTI 2014/2015 (Daily)
Larger Image

 

Back to homepage

Leave a comment

Leave a comment