Why you should financial model the Yom Kippur War

The recent OPEC+ decision to cut oil output by 2 million barrels per day is giving me a case of PTSD from a Yom Kippur long ago. In October 1973, the stock market was just getting over a case of Nifty Fifty growth stock mania. Arab armies, led by Egypt and Syria, made a surprise attack on Israel on Yom Kippur and overwhelmed the surprised defenders. The Israelis eventually prevailed in the conflict with US help. Arab oil-exporting countries responded with an oil embargo that spiked energy prices and caused a deep recession. The stock market fell roughly -50% on a peak-to-trough basis before recovering.

Fast forward to 2022. Instead of the Nifty Fifty, we have the FANG+ mania, which may be show signs of fading. Instead of a Middle East war, we have the Russo-Ukraine war. Instead of an Arab Oil Embargo, Russia has weaponized energy, mostly against the EU. Despite much lobbying by Washington, this year's Yom Kippur brought an OPEC+ surprise. The organization made a decision to cut oil output by 2 mbpd. While the cut isn't as bad as it sounds because a number of OPEC members aren't producing at capacity, the decision nevertheless shows that the US and Europe have no allies within OPEC. As a consequence, Street analysts are scrambling to raise their oil price forecasts, and higher energy prices are likely to put pressure on the Fed to stay hawkish.

Will investors see a repeat of the 1973-1974 bear market in 2022-2023?

The full post can be found here.

Re-branding the oil sands

The headline in the Globe and Mail blared Ottawa fights EU's dirty fuel label on the oil sands. Indeed, Canadians have been getting pressure from a number of quarters in the environmental movement over the issue of how oil is extracted from oil.

I've thinking that this label of "dirty oil" could be just a problem of re-branding. The environmental movement has done this very effectively in the past. Consider how:

• The jungle (think hot, steamy and snake infested) has now become the rain forest.
• Swamps (aligators and mosquito infested, etc.) are now wetlands.

I was at a lunch last week with some investment bankers when one suggested that the whole process is one giant environmental cleanup. We are cleaning up a natural environmental disaster and supplying the world with energy, a win-win proposition.

There is a federal election in Canada. Is anyone listening to this idea? Will anyone stand up for the country this way and become Kaptain Kanada (which incidentally is another re-branding effort)?

Is this the Top? Or a minor pullback?

Despite many of the macro risks that face the market, my models and indicators are telling me that the current bout of weakness is just a minor pullback to be bought, rather than a more serious intermediate term top, which I expect to develop later in the year. My conclusion is based upon the following:

• Model: The Inflation-Deflation Timer Model, which is a trend following model as applied to commodity prices on the basis that commodities represent the "canaries in the coal mine" of global growth and inflationary expectations, remain bullish on the "inflation" or "risk" trade.
• Technical: Secondary indicators of risk aversion are still trending towards the "risk-on" trade.
• Industry fundamentals: Current market weakness is based largely on fears of the effects of a cutoff in Libyan oil output and how such a price shock might impact the fragile global economy. Analysis shows that the expected effect of any disruption is likely to be minor. The markets appear to be starting to discount the worst case scenario a contagion effect of the popular unrest spreading to Saudi Arabia.
• Sentiment: A surprising quick retreat in bullish sentiment in the AAII surveys after this week's market weakness is contrarian bullish.

For the time being, my base case is that the current market action represents a minor correction. Should the weakness continue and violate the uptrends evident in the indicators, then my risk control discipline would then turn more defensive.


Inflation-Deflation Timer Model
The Inflation-Deflation Timer Model looks for a price trend in commodity prices, largely because commodities are considered to be a highly sensitive real-time barometer of global growth and inflationary expectations. A look at the CRB Index shows that commodities remain in an uptrend.

Given the recent geopolitical turmoil in the markets, it would be expected that headline commodities such as oil and gold would be in rally mode. But the Timer Model considers all commodities, not just precious metals and energy. Last week, before the Libyan unrest news hit the tape, it was the turn of softs and agricultural commodities to rally (remember all the news about food inflation in the emerging markets)? In fact, softs such as cotton have taken it on the chin this week.

Net-net, the entire commodity complex remains in a healthy uptrend. In particular, the price of Dr. Copper is staying in an uptrend.

Risk aversion measures still trending to "risk"
As well, the intermediate term trends in the risk aversion measures remain in "risk" mode. Consider, for instance, the ratio of Consumer Discretionary to Consumer Staple stocks as an indicator of the cyclical, or reflation trade:

We see a similar pattern in the relative chart of the Morgan Stanley Cyclical Index compared to the market:

Some of these indicators, such as the copper price and the Consumer Discretionary to Staple ratio, are testing their uptrend lines. Until we see violations of these trendlines, my inclination is the give the bulls the benefit of the doubt for now.


Oil shock analysis
James Hamilton has written extensively on the effects of oil shocks on the US economy. His latest analysis indicates that any effects of any Libyan supply disruption are likely to be minor [emphasis added]:

Libya recently accounted for a little over 2% of global oil production. If this is entirely knocked out, it would represent a shock that is only 1/3 the size of the smallest of the first 5 historical disruptions summarized above, and perhaps comparable to Venezuela-Iraq in 2002-2003...


The particular dynamic model from which the above Brookings figure came builds in quite strong nonlinearities and threshold effects. Interestingly, according to that specification, one wouldn't begin to anticipate significant effects on U.S. GDP until the price of oil got above about $130 a barrel, or until the second half of this year. Prior to that, according to that specification, we're still ok.


I don't want to make too strong a claim about those particular details. It's very hard to claim precise statistical evidence in support of one choice of a threshold over another. But, this particular model has held up fairly well since its original publication in 2003. So I'm not about to abandon it just yet.

My bottom line is that events as they have unfolded so far are not in the same ballpark as the major historical oil supply disruptions, and are unlikely to produce big enough economic multipliers that they could precipitate a new economic downturn. They might shave a half percent off annual GDP growth, but I don't anticipate a whole lot worse than that.

The current level of market panic appears to be related to the risk that the Tunisian/Egyptian/Libyan unrest contagion could spread to Saudi Arabia. Already, the House of Saud has responded with a giveaway:

Saudi Arabia's King Abdullah returned to the kingdom Wednesday after a three-month absence for medical treatment and introduced a number of nonpolitical reforms amid regional uprisings that have toppled regimes in Tunisia and Egypt and infected neighboring Bahrain.


The social and economic overhaul, estimated to cost around 135 billion Saudi riyals ($36 billion), include housing support, funding to offset inflation and guarantee of payment for students overseas, according to a series of royal decrees published on the official Saudi Press Agency, or SPA. They come as political upheaval continues to sweep the Arab world.

We can get an idea of the level of tension in the markets by monitoring Intrade for an assessment of the stability of the government of Saudi Arabia's neighbors. Currently, the odds that Prime Minister Khalifa Bin Salman Al Khalifa is no longer the Prime Minister of Bahrain by December 31, 2011 is about 60%. To the south, the odds that Ali Abdullah Saleh is no longer the President of Yemen by December 31, 2011 is about 65%.

The markets appear to be focusing on the nightmare scenario based on the threat of political turmoil to Saudi Arabia's neighbors. When markets start to discount the worst, it is time to buy. However, given the level of these Intrade odds, the risk premium may continue to rise and there may be further downside to this correction.


Is the retail investor capitulating already?
The final bullish underpinnings to this market is the recent reading out AAII showing that bullish sentiment fell from 46.6% to 36.6% in a single week. Given that the survey was done on Tuesday and there has been further weakness since then, it is likely that bullish sentiment has deteriorated further. Such levels of panic in the face of minor weakness is generally viewed as contrarian bullish.

Crude oil close to a bottom

In contrast to my last post on gold indicating that the correction in bullion has further to go, the sentiment picture for crude oil is far more constructive. I now have doubts as to whether my near term $100 oil call will come to pass.


Investor sentiment now very negative
Sentiment surveys on crude oil show that readings are now at bearish extremes, which is contrarian bullish. In addition, the CFTC Commitment of Traders data shows that large speculators, or hedge funds, have sold down their crude oil positions near levels where bottoms are seen. Indeed, COT Timer has flashed a buy signal for crude oil this week.




My estimate of mutual fund positioning is also encouraging for the energy sector. Consensus mutual funds have sold down their energy holdings to a market weight from an overweight position. By contrast, smart funds remain overweight the sector.




Long term bullish on oil
I have stated the case to be long-term bullish on oil before. In addition to those reasons, Barry Ritholtz at Big Picture found a great chart showing the growth path of world GDP and oil demand as another reason to be long-term bullish on crude.


Volatility a function of tight supply?
Commodities have always been volatile. Recently the oil price has been more volatile than usual with the market seeing regular $3-5 daily swings. Kurt Cobb postulated that queueing theory could explain oil's wild price swings. You could also argue that the current tight supply condition is acting like an inventory control model. The shifts in demand and the fact that incremental production can be brought on at much lower pricing, though with a lead time, suggest that the level of minimum inventory is highly variable. Include the fact that some of the investments are highly levered also adds to the volatility of minimum inventory level.


Buy oil/short gold?
Given these conditions on gold and oil traders could consider buying crude oil and shorting gold. Note that this is a tactical trading call and there are considerable risks involved. Most notably, the chart of the oil to gold ratio below shows that oil is already extended in favor of oil.

More constructive on crude oil

In retrospect it was easy to call the top in oil. When cartoons like this appeared it was clear that high oil prices had penetrated the public consciousness – a contrarian sell signal.

Now that the oil price has descended about $30 from its peak and other commodities have also been hammered, it’s time to become more constructive on crude. While downside risks remain (e.g. cyclical US slowdown affecting commodity prices, China slowing, US$ in rally mode, etc.), I would like to review the bull case for oil prices and detail the reasons why I remain a long-term oil bull.


Peak Oil
I could go on and on about Peak Oil but I refer you to the site Oil Drum and Matt Simmons’ speeches for more detail. It isn’t about the world running out of oil but more about world oil consumption running into extraction limits. Robert Hirsch wrote an important report for the US Department of Energy back in 2005 discussing these concepts and how to mitigate their effects.

Peak Oil Concepts

Peak Oil mitigation: 9 women can’t have a baby in 1 month
Hirsch’s conclusion was that the US needs to invest in alternative technologies now, because mitigation technologies take time. Put it another way: nine women can’t have a baby in one month – no matter how hard they tried.

If we are indeed facing Peak Oil in the immediate future then the secular trend for energy prices is up and will continue to rise until a combination of alternative energy and conservation measures kick in. This bull would have a long way to go.


Global cooling?
What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

Heebner still bullish on Energy
In s post back in early June comparing Bill Miller and Ken Heebner, I noted that Ken Heebner had a hot hand largely because of his overweight position in resources and underweight position in Financials. Moreover, Heebner does not hesitate to turn over his portfolio if he thinks that it is positioned improperly.

The chart below shows the Heebner’s latest imputed position in the Energy sector. Despite the recent rally in Financials and the air pocket hit by Energy, Heebner may have trimmed back some of his Energy overweight and is now adding back to his position.



You have to respect Heebner's views given his record.


Investor sentiment is bearish
Finally, in the short term, investor sentiment on crude has retreated to levels that warrants taking a less bearish stance. While oil prices may not rocket up from these levels, these readings do suggest a period of stabilization or consolidation in price.

A nervous bull on oil
Given that oil prices have retreated about $30 from their peak, I believe that the near-term upside and downside price risks are far more balanced and would be inclined to be more constructive on the oil price. Does that mean that it can’t go down any more? Of course not, there remain substantial risks to buying here. However, if you are playing the odds then the probabilities are now tilting more in favor of the bulls.

Addendum: The chart estimating the CGM Focus position in Energy has been corrected as the previous x-axis was incorrect. Apologies for any inconvenience.

Sheep can make money too!

As a counterpoint to my post Channeling my inner contrarian I thought that I would write about being a sheep and the advantages of following the crowd.

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

With those principles in mind, here are some of the big macro trends that could be investment opportunities (and this shouldn’t be a surprise to most people):

• The falling US Dollar
• Worldwide inflation, especially in commodity prices
• Growth in China

The falling US Dollar

The accompanying chart shows the US Dollar Index in a multi-year downtrend (this is where technical analysis is useful as it spots long term trends). The currency is reflective of investor concerns of the current account and fiscal deficits going out as far as the eye can see and no meaningful policies to reverse them. The recent Fed actions of rescuing the system from collapse have led to some to question the Central Bank’s inflation fighting credentials, which have resulted in additional Dollar weakness. In the short term, however, the US Dollar is near the bottom of its channel and seems to be poised for a counter-trend rally.


Worldwide inflation, especially commodity inflation
Inflation is everywhere and spreading. You just have to read stories like Stop the inflation in the US and Workers strike at Nike contract factory and demanding 20% raises in Vietnam, a low-wage country that had previously been a source of deflation.

Commodity inflation is not just restricted to headline commodities like gold and oil, but is very broad based can be seen in foodstuffs (which begs the question of whether Core CPI = CPI ex-food and energy is a good indicator of inflation). The accompanying chart shows the Continuous Commodity Index (CCI), which is a continuation of the old equal-weighted CRB Index before its re-constitution to a liquidity-weighted index in 2005. The CCI has been advancing in the major non-US currencies as well as US Dollars, indicating that the commodity advance is 1) broad based and 2) independent of US Dollar weakness.





Similarly, gold prices have also been showing a similar pattern to the other commodities. Gold appears to be regaining its former status as the alternative reserve currency. As I indicated before, the US Dollar is likely to rally in the short run and gold and other commodities would run into a headwind under such a scenario.




"Peak Oil" is an additional possible bullish dynamic for oil prices
Crude oil has a possible bullish dynamic of its own in addition to the rising trend in commodity prices: Peak Oil. Much has been written about peak oil by the likes of Matt Simmons, various contributors at the Oil Drum and by many others at APSO so I won't repeat them here. If the peak oil theory is correct and world oil production is indeed rolling over, then we are in for a period of very tough adjustments in not only energy usage but in the pattern of economic growth.

Growth in China
The China growth story is well known and likely to persist. However, direct investment in China is problematical because of an ill-formed culture of corporate governance. A recent article in the FT indicates that:

Board structures at Chinese companies can lead to “confusion, ambiguity and potentially ... undermine the board of directors”, according to a study [by Risk Metrics] of the corporate governance risks faced by investors in China.

Even Hong Kong has its problems:

Risk Metrics noted minority shareholders in the two jurisdictions [Mainland China and Hong Kong] do face some common risks. The state’s firm grip over China’s largest industrial and financial companies is mirrored in Hong Kong by the influence of tycoons and their families.

Instead of investing directly into China, I would suggest vehicles such as the Korean market (EWY: iShares MSCI South Korea) as a way of participating in Chinese growth. Countries such as Japan and Korea supply China with capital goods to facilitate growth in the Chinese economy. The accompanying chart shows the relative returns of the South Korean KOPSI Index in US Dollars relative to the S&P 500. The Korean market bottomed out relative to the S&P 500 in 1997 and has been in a relative uptrend since. A trend following investor would look at that chart and say “stay with the trend!”



The key risk to this trade is that the South Korean market is generally thought as as being highly sensitive to world growth and a significant slowdown in the US could affect it disproportionately.

Still more upside potential in the NatGas vs. Oil trade

Back in early December I posted about the oil and natural gas divergence in price and sentiment. Natural gas initially declined against crude oil after that post but has since risen about 10% on a relative basis.

A update of the Commitment of Traders data from the CFTC shows the relative bull case for natural gas vs. crude oil remains intact. The "fast money" large speculators continue to be have a crowded short in natural gas and giving a contrarian bullish signal. On the other hand, the signal from the COT data for crude oil is still neutral.

Energy stocks ready for another upleg?

LT Uptrend + Breakout + Neutral Sentiment = Bullish

Energy stocks may be ready for another upleg for three reasons.

Long term uptrend: the first chart shows the relative ratio of XLE (Energy Select SPDR ETF) to SPY (S&P 500 SPDR ETF). As you can see the Energy sector has been in a long term relative uptrend against the market, as defined by the S&P 500. As oil prices approached $100 and pulled back, so did the Energy relative to the market.

Relative strength breakout: the sector broke out to an all-time relative high against the S&P 500 in mid-December.



Neutral mutual fund sentiment: Using the technique shown in the sidebar (titled Reverse Engineering a Manager's Macro Exposure) I imputed the average Energy sector exposure of 22 US large cap blend equity mutual funds. These 22 funds can be thought of as a composite of the S&P 500-like mandate funds from the largest mutual fund complexes. As you can see from the chart, mutual funds moved from a significant overweight to a neutral/underweight position in the Energy sector.

In future posts I will highlight other divergences and opportunities within the Energy space.

An interesting Oil and NatGas divergence

Natural gas hasn’t followed the rally of crude oil. Even as crude oil approached $100 natural gas languished in the $7-8 range, compared to the highs of $14-16 seen in late 2005. The accompanying change shows the ratio of the price of natural gas to crude oil futures. I have used the 12-month strip as the reference prices (1/12th the front month + 1/12th the 2nd month + … + 1/12th the 12 month future) as natural gas prices can be seasonal. The chart shows that natural gas prices are probing new lows against oil prices.

A look at the Commitment of Traders data from the CFTC shows a very different kind of story. Commercial traders, who are usually thought of as the “smart money”, are excessively long natural gas and giving a bullish signal. On the other hand, the signal from the COT data for crude oil can be best described as neutral.

As a former trader I can attest that all these fundamental and sentiment signals don’t matter until they matter. Others have traded successfully on COT data but I have found them problematical as a timing tool. These conditions have persisted for several weeks. Just because these conditions are at extremes doesn’t mean that they can’t get stretched further.

In future posts I will examine other interesting divergences in the energy and energy related markets.