Why You Should Be Wary About the Oil Price Heading Higher

Our central banking overlords and puppeteers clearly love this…

The Dow Jones Industrial index jumped another 0.8% overnight as the market grows increasingly comfortable with the Fed raising interest rates in the coming months.

At least that’s the latest narrative to grip markets. Here it is nicely wrapped up by Bloomberg:

Don’t fear the Fed is the new mantra for global markets.

U.S stocks rose to their highest level in almost a month amid mounting investor optimism that the world economy can withstand higher interest rates from the Federal Reserve.

Behind all the noise though, here’s what you need to know. The driving force behind the market’s recent rise is the rally in bank stocks. Banks like the prospect of higher interest rates because it allows them to earn higher margins on their traditional lending activities.

You can see this in the performance of the Philadelphia Bank Index below. Overnight, the index closed at its highest level for 2016.

Source: Market Analyst

Click to enlarge

The prospect of higher rates is due to renewed optimism about the US economy. Recent data showed the US housing market continued to recover. This seemed to take the market by surprise.

Readers of Cycles, Trends and Forecasts are well aware of the ongoing recovery. They know that there is a long way to go before US real estate blows another gasket.

But that doesn’t mean an interest rate rise is a done deal for June. In a sign of the need to hedge their bets, St Louis Fed President James Bullard said overnight that a June rise was ‘not set in stone.

Perhaps he was concerned with data showing the huge US services sector slowed during May. The reading for the Markit US purchasing managers index (PMI) came in at 51.2, down from 52.8 in April, and well down on the average reading for 2015 of 56.

A reading over 50 denotes expansion, so these numbers tell you that, while the US services industry continues to grow, it is doing so at a slower rate.

In other words, there are quite a few cross currents in the US economy right now. Just because the market is all fired up about a June rate rise doesn’t mean it will happen. In fact, the narrative can turn quickly, depending on the data release.

The other important piece of the jigsaw puzzle is oil. The rally from the lows of early 2016 continues; this is also providing support to the market.

As you can see in the chart below, the price of Brent crude nearly hit US$50 per barrel last week. The rally from the low of nearly US$28 per barrel in January this year has taken a lot of pressure off the global financial system.

Source: Market Analyst

Click to enlarge

The rout in the oil price threatened to turn a huge amount of debt ‘bad’. That was a big threat to the stability of the global banking system. Now the oil price rally has taken that pressure off.

What’s surprising is to see oil rally in the face of a strengthening US dollar. Connecting the dots, the prospect of an interest rate rise boosts the US dollar, which should put pressure on non-dollar assets like oil.

But oil has shrugged it off. Whether it can continue to do so is another question. As far as I can tell, there hasn’t been much of a change to the fundamental story. That is, there is still plenty of supply around.

Not surprisingly, the culprit for the persistent rally relates to positioning in the futures market. Check out the chart below, from Saxo Bank. It shows the oil market position of ‘managed money’ — mostly hedge funds.

There are two things to take note of. Since late 2015, hedge funds increased their bullish bets (blue line rising) and decreased their bearish bets (red line falling).

The result of this is that the ‘net long’ position (bullish minus bearish bets) is now the highest it has been since at least 2011. Given the abundant supply still in the market, that is a little concerning.

Source: Bloomberg, Saxo Bank

Click to enlarge

In Brent crude, the ratio of longs to shorts is 16:1!

The oil market has had a great rally, but it is now very stretched. I’d be wary of a decent pullback from here.

Unfortunately for Australia, one commodity that hasn’t proved anywhere near as resilient is iron ore. It’s coming back down to Earth fast.

Qingdao port prices fell another 1.2% yesterday, to US$50.40 per tonne. 12-month futures are at US$37/tonne. The iron ore stocks don’t seem to care though. They’re trading in line with the general bullishness of the market.

When I say general bullishness, what I really mean is indiscriminate bullishness. It’s hard to argue that the outlook for earnings is particularly good, yet stock prices are rising strongly.

Perhaps the combination of lower rates in Australia, and higher rates in the US, is the perfect combination for Aussie stocks? Or perhaps the market has just lost its head for the time being.

We’ll know more shortly. The ASX 200 is trading right on 5400 points this morning. As I’ve pointed out before, this is a crucial level for the market. A close above here will be a positive, pointing to more gains for stocks.

Let’s see whether the market remains strong into the afternoon. More on that tomorrow…

Cheers,

Greg Canavan,
For Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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