Tuesday, December 16, 2014

the Crude Reality in Oil

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.
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. 
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.

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 in November may be a leading indication that the dollar - like the equity markets, are butting up against the limits of their respective trends. 
Historically speaking, the same leading nature in gold has been present in the past with upside reversals in oil.
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. 
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. 
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. 
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.