Update: What To Look For When The Price Of Oil Has Bottomed

Summary: the price of oil has fallen 30% in a month and is still forging new lows. "Smart money" thinks the low is near, and "dumb money" sentiment is at a 15 year trough, so it possible a reversal could arrive soon. However, the best approach for investors is to first wait for a sign that big buyers are interested: look for a "higher low" in price and for the downward momentum to dissipate. Neither of these has happened yet. This was the pattern at other major lows in oil.

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In February, we took a look at prior times over the past 30 years when the price of oil had fallen by more than half (here).

Our conclusion was that oil had probably not bottomed. In the event, oil formed a low a month later, in March, from which it rallied nearly 50%. It has since fallen all the way back to its prior lows.

So, what happens next? Right now, there is no clear indication that price has bottomed.

We previously drew several conclusions about what to look for at price bottom. The current price pattern is similar to two other instances. Let's review each one.

In 1986, the price of oil fell sharply and quickly, just like it has in the past year. The first rally failed near the 50-dma (blue line; arrow). Price retested the low the following month, then rallied into May before retesting the low again 4 months later in July (second circle).

The Impact of Oil and the Dollar on 2Q Financials

Summary: 2Q financials have been poor, with negative growth in both sales and EPS. Sales growth has been affected by a 50% fall in oil prices and 15% fall in the value of trading partner currencies. Both of those are likely to make upcoming 3Q financials look bad as well.

Of note is that profit margins are still expanding for most sectors.

Looking ahead, perhaps the biggest wildcard is the dollar, which historically weakens after interest rates start rising. This would be a boon to the roughly 40% of S&P sales and profits that are derived from overseas.

Especially for their rate of growth, S&P valuations are high. Even if sales and EPS growth start to pick up, valuations are likely to remain a considerable headwind to equity appreciation.

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About 87% of US corporates have reported their financial results for the 2nd quarter of 2015. What have we learned?

Using figures from FactSet, EPS growth in 2Q is tracking minus 1.0% (year over year) versus an expected growth rate of minus 1.9% on March 31st when the quarter began; sales growth is tracking minus 3.3%, exactly as expected when the quarter began.

Although EPS turned out to be better than expected while sales met expectations, neither result is impressive as both are down from last year.

By now it should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was over $100 in the 2Q of 2014; it fell 50% to an average of roughly $55 in 2Q of 2015.

August Macro Update: A Recession Is Not Looming Ahead

Summary: This post reviews the main economic data from the past month.  Most, but not all, of the data was positive:

• Employment growth is the best since the 1990s, with an average monthly gain of 243,000 during the past year.  
• Compensation growth is positive but not accelerating: 2.1% in 2Q15.
• Personal consumption growth the last two quarters has been the highest in 8 years: 3.1% in 2Q15.  2Q15 real GDP grew 2.3%, near the upper end of the post-recession range. 
• Housing starts are near an 8 year high. New home sales in June rose 18% yoy. 

The main negatives are:

• Core durable goods growth fell 3.5% yoy in June. It was weak during the winter and there has been little rebound since. Industrial production is also weak, growing at just 1.5% yoy, one of the low rates in the past 15 years.
• The core inflation rate remains under 2%. It is near its lowest level in the past 3 years.  

Bottomline: the trend for the majority of the macro data remains positive. The pattern has been for the second half of the year to show increased strength.

Prior macro posts from the past year are here.

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Our key message over the past year has been that (a) growth is positive but modest, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages

The July non-farm payroll was 215,000 new employees. In the past 12 months, the average gain in employment was 243,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000. That has been a pattern during every bull market. The low print of 119,000 in March fits the historical pattern.

Insiders Are Bullish While Outsiders Are Bearish

Summary: Corporate insiders are bullish equities at precisely the same moment that outside investors have become bearish. Other factors may intervene to drive the price of equities lower. But sentiment, at least short-term, is quite clearly biased in favor of higher prices.

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There's a marked divergence of opinions in the US stock markets at the moment.

On bearish side are equity investors. The ISE equity-only call/put ratio has closed below 100 in each of the last 3 days. This means equity investors are buying protection against falling share prices to an extreme degree. In other words, they are bearish and this is normally a positive for equity prices.

This ratio has only twice before closed below 100 three days in a row: mid-March and mid-November 2008. In both cases, the S&P was near a short-term low and rose over 10% in the weeks ahead. Both of those rallies later failed.

Weekly Market Summary

Summary: There are several breadth and sentiment indicators that suggest the indices have reached, or are near, a one month low. But more importantly, for the first time in awhile it is possible to see an endgame to the sideways trading range that has persisted in 2015. A break lower soon, should it occur, would likely lead to a washout low. This is the set up for US equities as seasonally weak August begins.

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Our view at the end of 2014 was that 2015 was likely to be unremarkably flat. This was to be a year where stock appreciation would take a break while sentiment and valuations cooled off and the economy improved (post).

Sideways markets are not unusual. Periods like the one we are in now can last as long as two years. There is no decisively bearish implication of a sideways market either. It is, in fact, a pattern that is common within every bull market, a period of rest between periods of rapid price appreciation. We reviewed this topic in detail here. Similar instances to today are shown below (this and all charts expand when clicked).