- Interim Update 11th March 2020

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The Oil Crash

The governments of Saudi Arabia and Russia, the world's two largest oil exporting countries, have decided to 'play chicken' with each other regarding oil supply and pricing. This caused a spectacular decline in the oil price on Monday 9th March.



The physical supply-demand situation in the oil market, as indicated by the term structure of the futures market, was bullish (for the oil price) as recently as two months ago. Unsurprisingly, considering the games being played by the biggest oil exporters and the coronavirus-related reduction in demand, the term structure of the futures market now points to a bearish physical supply-demand situation. For example, crude oil for delivery in April-2020 is, as we write, trading at a 15% discount to crude oil for delivery in April-2021. This is indicative of a market with abundant short-term supply.

However, the oil price has reacted so violently to the bearish shift in fundamentals that the 9th March low of around $27 could be the ultimate low.

Regardless of whether or not Monday's low marked the end of the 2020 oil crash, over the past few days many oil-and-gas (O&G) equities have traded at price levels and through price ranges that can be aptly described as insane.

The trading of Enable Midstream Partners (ENBL), the stock that we added to the TSI List at US$3.40 during the early going on Monday 9th March, is an excellent example. The stock ended last week at US$5.00, at which point its distribution yield was already extremely high at around 26%. On Monday it traded as low as (and closed at) US$1.86, giving it a distribution yield of 71%! On Tuesday it gained 154% (!!) to close at US$4.73 and on Wednesday it gained another 8% to close at around US$5.00. So, over the first three days of this week ENBL went from $5.00 to $1.86 and back to $5.00.

ENBL operates a boring natural-gas transportation business with annual sales of about US$3B and consistent positive cash flow. Its market value should not be swinging wildly from day to day. Clearly, believers in the Efficient Market Hypothesis do not have much in the way of real-life market experience.

The O&G sector now offers one of the best buying opportunities we have ever seen. Some stocks have rebounded strongly from Monday's extremes, but most are languishing at/near historic lows. However, that doesn't mean you should be 'backing up the truck'. There's never any way to know, in advance, how irrational things will become on either the upside or the downside before common-sense and level-headed value investing start to gain the upper hand, so it is almost always prudent to change market positioning methodically over time.

The Inflation Expectations Crash

Inflation expectations have crashed along with the stock market and the oil price. This is evidenced by the following chart of the "Expected CPI", where the Expected CPI is calculated by subtracting the 10-year TIPS yield from the 10-year T-Note yield. Since the advent of the TIPS market in 2003, the Expected CPI was only below this week's low during the final few months of 2008 and the first few months of 2009.



The collapse in inflation expectations over the past several weeks does not indicate that "inflation" will be much lower in the future. On the contrary, it makes higher "inflation" more likely.

Over the next few months the CPI will be lower than would have been the case in the absence of the coronavirus-related restrictions to economic activity and the plunge in the oil price, but by this time next year the CPI probably will be much higher due to the following:

1) Aggressive central bank reactions to the economic slowdown and the stock market plunge. These reactions will distort prices and hamper the economy, but to a man with nothing except a hammer every problem looks like a nail. To a central banker, every economic problem other than obvious "price inflation" looks like a reason to create more money out of nothing. Also, to the central bankers of the world the recent rapid decline in inflation expectations is like a giant cattle prod that very quickly will push them further in the direction of pro-inflation monetary policy.

2) In addition to aggressive monetary stimulus there will be aggressive fiscal stimulus. This would be the case anyway under such circumstances, but in the US the short-term stimulus from increased government spending will be more aggressive than usual due to Trump's fear that economic weakness will spoil his chance of winning a second term.

3) Once the coronavirus threat dissipates, there will be the natural release of pent-up demand.

Adding the natural force of pent-up demand release to the unnatural forces of monetary and fiscal stimulus should mean that "inflation" will be materially higher a year from now than would have been the case in the absence of the Q1-2020 calamity. Our prediction: During the first half of 2021 the official US CPI, which routinely understates the increase in the cost of living, will print above 4%.

The Stock Market

The discussion of the current stock market situation included in the email we sent to subscribers in response to Monday's market drama remains applicable and therefore is repeated herewith:

"We have been expecting a test or breach of the 28th February low (around 2850 for the SPX), but not as soon as this week. In broad-brush terms, the expected pattern involved 1) an initial extreme, 2) a choppy multi-week rebound that retraced about half of the initial decline, and 3) another leg down that either successfully tested or decisively breached the price at the initial extreme. The time from the initial extreme to the final low is usually 5-8 weeks, which is why we wrote in the latest Weekly Update that a decline this week that resulted in a daily close below the 28th February low would be a significant deviation from the expected pattern.

Due to adding the news over the weekend of an 'oil price war' between Saudi Arabia and Russia, the world's two largest oil-exporting countries, to the on-going stream of negative news regarding the coronavirus, the stock market crashed anew on Monday 9th March and the SPX closed about 100 points (3.5%) below its 28th February low. Furthermore, there was sufficient market-wide panic on Monday 9th March to drive several technical indicators beyond the extreme levels reached on 28th February. For example, on Monday there was an 8-year low in the NASDAQ McClellan Oscillator, an 11-year high in the VIX, a rise in the gold/silver ratio to test its 70-year high near 100, and the second-largest number ever of individual NASDAQ stocks making new 52-week lows on a single day.

This suggests that 28th February wasn't the initial extreme. Instead, it looks like the initial extreme will be put in place this week. There should then be a volatile multi-week rebound followed by a decline that tests (or breaches) this week's low."

Although the SPX traded at a new low for the year on Wednesday 11th March, the indicators mentioned in our email have not exceeded Monday's extremes. Here are charts illustrating three of the most significant extremes.

The first chart shows the 8-year low registered by the NASDAQ McClellan Oscillator on Monday 9th March.



The next chart shows Monday's post-GFC VIX high.



The final chart shows the daily number of individual NASDAQ stocks making new 52-week lows. As mentioned in our email earlier this week, there has been only one day in history when the number of individual NASDAQ stocks making a new 52-week low was greater than it was on Monday 9th March 2020. That day was in October of 2008, near the crescendo of the Global Financial Crisis (GFC).



In our email earlier this week we concluded: "...it looks like the initial extreme will be put in place this week. There should then be a volatile multi-week rebound followed by a decline that tests (or breaches) this week's low."

Does this week's low have to be tested?

No, it doesn't have to be, but it's rare for a major 'oversold' extreme not to be tested. The following chart of the NYSE Composite Index (NYA) shows that even the October-1987 crash low was tested several weeks later, and the market was more stretched to the downside and a lot cheaper at the 1987 crash low than it was at this week's low.

Significantly, in 1987 the majority of NYSE-traded stocks made their lows for the year during the October crash, even though the NYA made a new low for the year in December. That's normal. The implication is that the majority of stocks could well have made their correction lows during the first half of this week even if the senior indices are destined to make lower lows within the next several weeks.



The stage is set for the extreme volatility to continue over the final two trading days of this week. As we write, S&P500 futures are more than 100 points lower and Dow futures are more than 1,000 points lower in reaction to Trump's announcement that travel from Europe to the US will be suspended starting on Friday.

Gold and the Dollar

Gold and Silver

The Ratio

During periods when economic confidence plunges, the gold/silver ratio acts like a credit spread. Since early-January and specially since mid-February, economic confidence has plunged and credit spreads have widened substantially. Consequently, it isn't surprising that the gold/silver ratio has moved sharply higher.

Here is a chart that illustrates what we just described. On this chart the black line is a credit-spread proxy and the gold line is the gold/silver ratio.



In other words, over the past two months silver has performed the way it is 'supposed to' relative to gold. When the crisis abates and economic confidence begins to rebound, the silver price will rebound relative to the gold price.

The Recent Price Action

The US$ gold price has pulled back a little, but it is still close to a 7-year high. It could chop around at a high level for as long as the fundamental backdrop remains very supportive, which could mean a few more days or few more weeks or even two more months. It could even make a new multi-year high, although any new high within the next couple of months probably would be marginal. However, at some point in the not-too-distant future the panic regarding the coronavirus will subside and the huge speculative net-long position in the gold market will start being unwound. We suspect that this will result in the gold price declining to around the mid-$1400s, although the magnitude of the correction will be determined in part by how quickly the speculative net-long position shrinks.



Even though the US$ gold price is close to its recent 7-year high, the US$ silver price is close to a 7-month low and looks set to fall further.



The recent disparity between the performances of gold and silver is consistent with the overall financial/economic backdrop, but it has emphasised a non-confirmation that has bearish implications for both metals. The non-confirmation was discussed in the 10th February and 17th February Weekly Updates, and was formed by the following sequence:

1) Large multi-month rallies in the prices of both metals.

2) Significant short-term corrections in both markets.

3) A rally to a new high in the gold price accompanied by a rally to a lower high in the silver price.

This sequence has been seen around a few important tops for the metals, including the 2011 top and -- perhaps more relevantly given what's happening in the stock market -- the 1987 top.

We suspect that silver will make a multi-month bottom in the $15.50-$16.50 range within the next few weeks, which implies that we aren't expecting a lot more downside. However, the historical pattern following bearish gold-silver non-confirmations of the type that occurred over the past six months suggests that after the current decline reaches its end there will be a long period of range trading between the February-2020 top and the March-April-2020 bottom.

Gold Stocks

The gold mining sector again plunged with the broad stock market on Wednesday 11th March. The HUI is now down by about 20% since its 24th February top and has just closed below its 200-day MA for the first time since May of last year.



In nominal dollar terms the HUI is not yet 'oversold', even on a short-term basis. However, in gold terms it definitely is. This is evidenced by the following chart, which shows that the HUI/gold ratio has just dropped to the bottom of a 15% envelope around its 40-day MA. The HUI/gold ratio hasn't been this stretched to the downside since the multi-year bottom in Q3-2018.



The HUI has support at 200 (that is, near the current level) and then 180. We suspect that the lower of these support levels defines the near-term risk.

We think that the gold mining sector is in a similar position to silver. It probably isn't far from a short-term bottom, but there isn't a good reason to expect that a rally to above the February-2020 high will happen anytime soon. Instead, several months of range trading between the February-2020 high and whatever low is put in place during March-April is likely. This is the probable response to conflicting forces, with the gold mining stocks being helped by stabilisation in the broad stock market and hurt by the decline in the gold price that is bound to occur after economic confidence starts to recover.

The Currency Market

The Dollar Index (DX) probably is in the early part of an intermediate-term downward trend. However, at the end of last week it was short-term 'oversold' and seemingly poised for a 1-2 week rebound.

The DX became more 'oversold' when it plunged to a 12-month low on Monday 9th March, but it then began to rebound. In the latest Weekly Update we noted that a routine correction could take the DX up to around 97.5, which is about one point above Wednesday's close. Both the 50-day MA and the 200-day MA are near 97.5.



Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

In the latest Weekly Update we wrote about Adriatic Metals (ASX: ADT). Our plan was to add the stock to the TSI List if it traded at A$1.10.

In sympathy with another general panic out of equities the stock traded as low as A$1.00 in the Australian market today and closed at A$1.01, so it has been added to the List at A$1.10.



Chart Sources

Charts appearing in today's commentary are courtesy of:

https://stockcharts.com/
http://bigcharts.marketwatch.com/
https://research.stlouisfed.org/