Crude oil: Opportunities and value traps

On the weekend we wrote that the bottom had fallen out of the oil market after Nymex crude broke support at $20 per barrel.

Now, the previously unimaginable has occurred, with Nymex Light Crude falling below zero for the first time in history, closing at -$13.10 per barrel with reports of intra-day lows at -$37.63.

WTI Crude

From The Age:

“Traders are still paying $US20.43 for a barrel of US oil to be delivered in June, which analysts consider to be closer to the “true” price of oil. Crude to be delivered next month, meanwhile, is running up against a stark problem: traders are running out of places to keep it, with storage tanks close to full amid a collapse in demand as factories, automobiles and airplanes sit idled around the world.

Tanks at a key energy hub in Oklahoma could hit their limits within three weeks, according to Chris Midgley, head of analytics at S&P Global Platts. Because of that, traders are willing to pay others to take that oil for delivery in May off their hands, so long as they also take the burden of figuring out where to keep it.”

Cushing Storage

Brent Crude is trading at $25.57 per barrel but a Trend Index peak deep below zero warns of similar strong selling pressure.

Brent Crude

Outlook

Crude oil production is still in a long-term up-trend. Low prices may present opportunities to buy cyclical stocks at historically low prices.

IEA Oil Production

The Oil & Gas sector has plunged as expected.

DJ US Oil & Gas

Oil infrastructure is also suffering from low activity levels.

DJ US Pipelines

Energy-consuming industries, however, may benefit from lower oil prices.

EIA: Industrial Sectors

Transport

Transport is the biggest consumer of crude oil products.

IEA Oil Sectors

If we break usage down by fuel types, the largest is diesel/gas, followed closely by motor gasoline, with jet kerosene significantly smaller.

Products from Crude

Airlines which have suffered from a massive drop in air travel.

DJ US Airlines

While delivery services (formerly air freight) are suffering from the collapse of global trade.

DJ US Delivery Services

So is marine transport.

DJ US Marine Transport
But trucking is holding up well.

DJ US Trucking

Construction Materials

Crude oil runs a distant second to coal as the chief energy source for cement production.

IEA Cement - Energy Usage

But the industry is a heavy transport user and should benefit from lower oil prices.

DJ US Construction Materials

Mining

Mining is also likely to benefit from lower extraction and transport costs.

DJ US Basic Materials

Forestry & Paper

Forestry is another heavy fuel user.

DJ US Forestry & Paper

Chemicals & Plastics

Basic chemicals (including fertilizers) are the largest industrial consumer of crude oil.

DJ US Chemicals

Specialty chemicals are also largely oil-based.

DJ US Specialty Chemicals

Aerospace & Automobiles

Aerospace, laid low by problems at Boeing (BA), has been floored by a massive downturn in the airline industry and will take a long time to recover.

DJ US Aerospace

Automobiles have so far stood up well because of stellar performance from the likes of Tesla (TSLA).

DJ US Automobiles

But the sting is in the tail. Light vehicle sales have plummeted.

Light Vehicle Sales

Low vehicle sales and less travel also means lower tire sales.

DJ US Tires

Oil Producers in Affected Regions

The IEA graph below shows producing regions that are uneconomic at varying prices/barrel (x-axis). If we take $25/barrel as the average over the next two years, North American producers would suffer the most, followed by Asia-Pacific and Latin America.

Uneconomic Crude Production by Country

Middle-Eastern producers enjoy the lowest extraction costs and are mostly still profitable at lower prices.

Avoiding Value Traps

Value opportunities abound in industries that are badly affected by the economic contraction and falling crude prices — as well as by those industries that stand to benefit from low oil prices. Some affected industries, however, are going to struggle to survive without state assistance.

The problem with value stocks is that, although they may seem cheap, prices can fall a lot further. That is why we use both technical and fundamental analysis to evaluate opportunities.

There are many stocks that are trading well below our assessment of fair value at present but we will not buy until the technical outlook turns bullish. It takes plenty of patience. But helps to avoid value traps.

The stock market remains an exceptionally efficient mechanism
for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

Dow: Not so fast WSJ

We were surprised to receive this from The Wall Street Journal this morning:

Markets Alert

Dow Industrials Rally, Ending Bear Market

A new bull market has begun. The Dow Jones Industrial Average has rallied more than 20% since hitting a low three days ago, ending the shortest bear market ever.

Dow Jones Industrial Average

That is news to us. A 20% reversal is a quick rule of thumb used by brokers. It is not part of Dow Theory. To suggest that we are now in a bull market is ludicrous.

Dow Theory tracks secondary movements in the index which last from ten to sixty days (Nelson, 1903). Only if the secondary movement forms a higher trough followed by a higher peak does that signal reversal to an up-trend. And the same pattern has to occur on the Transport Average to confirm the change.

A three-day rally is a normal part of a bear market and, with volatility near record highs, it is likely that some rallies are going to reach 20 per cent.

Dow Jones Industrial Average

Bear markets are more volatile than bull markets. You can see this from the volatility spikes above in 1991, 2000-2003, 2008, and 2020. Stocks go up on the escalator and down in the elevator.

According to data from S&P Dow Jones Indices, most days with the biggest gains occur in a bear market. Eighteen of the top twenty biggest daily % gains on the Dow occurred in a bear market. Only two (marked in blue) were in a bull market.

Dow Jones Industrial Average

The largest gains in the 1930s bear market were as high as 15% in a single day!

Interesting that eighteen of the top twenty biggest daily % losses on the Dow also occurred in a bear market (red).

Dow Jones Industrial Average

That is because volatility is a lot higher in bear markets than in bull markets.

So expect big moves in both directions.

ASX catches a virus

It’s not a pretty sight. The ASX 200 fell close to 10% in a single week. The severity of the fall suggests that sellers are committed and buyers are scarce. Breach of support at 6400 is highly likely and would offer a target of 5400 (a 25% draw-down).

ASX 200

A V-shaped recovery is unlikely.

The ASX 300 Metals & Mining index broke primary support at 4100, completing a double-top reversal with a target of 3400.

ASX 300 Metals & Mining

The Aussie Dollar is also getting smashed, headed for a target of 64 cents after breaking support at 67.

AUDUSD

The ASX 300 Banks index is headed for a test of 7250/7300. Breach is likely and would offer a test of 6750.

ASX 300 Banks

Our conclusion hasn’t changed from last week:

Threats continue to outweigh opportunities in our view and we retain a bearish view on the global and domestic economies. Our focus remains on defensive and contra-cyclical (gold) stocks.

A worm in the Apple

Apple Inc (AAPL) enjoyed stellar growth over the past 12 months, jumping more than 50%.

Apple Inc (AAPL)

But is that due to solid operating performance or window-dressing, with almost $140 billion of stock buybacks in the last two years?

Apple Inc (AAPL)

Free cash flow — operating cash flow less stock compensation and investment in plant and equipment — has been falling since 2015.

Apple Inc (AAPL)

And the company has depleted its cash reserves over the last two years, to fund stock buybacks. The graph below depicts the change in Apple’s net cash position (cash plus marketable securities less debt).

Apple Inc (AAPL)

So why the management enthusiasm for stock buybacks?

Is the stock a good investment? No. Free cash flow per share has barely lifted since 2015 despite $237.5 billion used to repurchase 1144 million shares.

Apple Inc (AAPL)

Apple have returned surplus cash to stockholders in the most tax-efficient way possible, by buying back stock rather than paying dividends. The added bonus is the reduced share count which gooses up earnings per share growth and return on equity.

Apple Inc (AAPL)

Investors in turn get excited and run up earnings multiples. The current price/free cash flow ratio of 23.2 exceeds that of the heady growth days up to 2015.

Apple Inc (AAPL)

The stock keeps climbing, supported by buybacks and rosy EPS projections. The problem for Apple is when they run out of cash, or exceed reasonable debt levels, then the band will stop playing and those heady multiples are likely to come crashing down to earth.

It’s not only Apple that’s doing this. The entire S&P 500 is distributing more by way of buybacks and dividends than it makes in earnings, eating into reserves meant to fund new investment.

S&P 500 Buybacks & Dividends

The result is likely to be low growth and even more precarious earnings multiples.

The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.

S&P 500 in a precarious position

A long-term chart of the S&P 500 highlights the precarious position of the index, having now doubled since its October 2007 high at 1576. Any time that a stock doubles in price, you are likely to get profit-taking, leading to resistance. The same holds true for the index. Probably even more so because individual stocks have the capacity to post higher gains — of even 5 or 10 times — while that isn’t feasible for the index. Even in the Dotcom bubble.

S&P 500

On the one hand we have a massive triple stimulus creating irrational exuberance, while on the other we have concerns over a coronavirus epidemic spreading from China and Donald Trump’s looming impeachment.

CoronaVirus

If you think that Trump is a shoe-in for re-election in November, this analysis of his chances is quite eye-opening.

Trump: Long Shot rather than a Slam Dunk

Expect more erratic behavior in the lead up to November.

ASX 200 retracement likely

A short candle with a tall shadow on the ASX 200 weekly chart warns of short-term selling pressure. Expect retracement to test the new support level at 6800.

ASX 200

Weakness has been driven by the Resources sector, with a gravestone candle on the ASX 300 Metals & Mining index warning of selling pressure at resistance at 4800 and a likely reversal to test support at 4450.

ASX 300 Metals & Mining

A short candle on the ASX 300 Banks index warns of increased short-term selling pressure. Respect of the descending trendline would signal another decline; breach of support at 7250 would confirm. Penetration of the trendline is less likely but would suggest that a bottom is forming.

ASX 300 Banks

We continue to hold a bearish view on the domestic economy but recognize that the temporary tailwind from resources (iron ore) may partly alleviate this. IT and Healthcare sectors are, in our view, over-priced and we maintain our focus on defensive and contra-cyclical (gold) stocks.

Bull Markets & Irrational Exuberance

Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:

“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.

As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.

That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”

Economy

The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.

Treasury 10 Year-3 Month Yield Differential

I rate economic risk as medium at present.

Political Disruption

US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?

Bonds & Interest Rates

I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.

Market Risk: Irrational Exuberance

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

ASX 200 lifted by resources

The ASX 200 is advancing towards its medium-term target of 7200 after breaking resistance at 6800. A high trend index trough signals buying pressure.

ASX 200

Primary driver of the advance is Resources. Signing of phase one of the US-China trade deal lifted iron ore, which is  testing resistance at 95. Consolidation at/below 95 is likely, however, given that the mid-2019 peak was caused by supply disruption in Brazil.

Iron Ore

The ASX 300 Metals & Mining index is headed for a test of resistance at 4800.

ASX 300 Metals & Mining

Financials are weak, but the ASX 300 Banks index found support at 7250. Respect of the descending trendline would warn of another decline, with a short-term target of 7000. Penetration of the trendline is less likely but would warn that a bottom is forming.

ASX 300 Banks

The ASX 200 REITs index is testing resistance at 1680, reflecting the investor demand for yield.

ASX 200 REITs

A weakening Australian Dollar may lift exports slightly but reflects concerns over the phase one US-China trade deal and the impact substantive purchase commitments made by China will have on other energy and commodity suppliers. Breach of 68.50 would offer a short-term target of 67 US cents.

AUDUSD

We continue to hold a bearish view on the domestic economy but recognize that the tailwind from resources may partly alleviate this. IT and Healthcare sectors are, in our view, over-priced and we maintain our focus on defensive and contra-cyclical (gold) stocks.

ASX Leading Sectors

The ASX 200 broke resistance at 6800, signaling a fresh advance. Expect retracement to test the new support level. Respect would strengthen the bull signal, confirming a fresh advance.

ASX 200 Quarterly

At the same time, fundamentals are distinctly bearish, with falling retail sales and dwindling GDP growth. So, what sectors are driving the index?

A comparison of the ASX 200 sector indices shows that the advance is led by Healthcare and Information Technology sectors, while the laggards are Financials, Utilities and Telecommunications.

ASX Sector Comparison

Top performers in Healthcare (with forward price-earnings ratio where available) are:

  • Polynovo (PNV) – negative eps
  • Clinuvel (CUV) – 79
  • Pro Medicus (PME) – 137
  • Nanosonics (NAN) – 158
  • Resmed (RMD) – 55
  • CSL (CSL) – 49
  • Fisher & Paykel Health (FPH) – 55

ASX 200 Healthcare Top Performers

In Information Technology, top performers are:

  • Afterpay (APT) – negative eps (forward pe 476)
  • Nearmap (NEA) – negative eps
  • Bravura (BVS) – 37
  • Appen (APX) – 58
  • Xero (XRO) – 5998 (forward pe 270)
  • Altium (ALU) – 63

ASX 200 Information Technology Top Performers

The graph below compares PE Ratios on the y-axis to required Annual Growth in earnings on the x-axis. The curve plots the compound annual growth (CAGR) required for a 20-year income stream to deliver a 12.5% return on investment.

PE Ratio compared to Expected Growth

What this illustrates is that PE Ratios above 50 should be treated with caution as they assume the ability to maintain high CAGR in earnings (e.g. above 20%) for long periods. Even when growing off a low base that can be difficult to achieve.

Bottom line: many stocks in these sectors (Healthcare and IT) are highly-priced and vulnerable to strong draw-downs.