In a bit of a delayed reaction to Treasury’s announcement of its $3 trillion borrowing needs in Q2, the 2s10s has pushed above the white TL connecting all-time lows – a clear warning, should it last, for equities.
Meanwhile, CL backtested its Feb 2016 lows and USDJPY broke down at about the same time that ADP announced another 20 million job losses (roughly in line with Friday’s NFP.) All of this came on the back of dismal earnings from market darling Disney.
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With May contracts in the rear view, we wondered whether oil markets would revert to some sense of normalcy. A steep contango continues, however, with June contracts assuming the role of the panic stricken expiration month.
Futures tested our initial downside target yesterday, the Fib 2.24 extension at 2728.79, and bounced overnight…
…as oil and gas prices bounced sharply off our downside targets…
…and VIX collapsed after tagging our backtest target.
The question, as is often the case, is whether the relief rally can continue once equities’ cash market reopens. And, will SPX ever get to test its own critical support?
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May WTI futures are off almost 35% since Friday’s close. 
This drops it below the 17.12 target we first identified in March 2019 when, at 59.32, CL had completed a rising wedge and tagged multiple channel lines.
Members might recall the 17.12 target was originally set for April 2023 in keeping with a March 2019 cycle study [see: Macro Factor Cycles and Regime Shifts.] The chart patterns and Fib levels fit nicely with the concept of a recurring 2600-day cycle for significant lows.
We’ve reiterated the 17.12 target many times, including last December as CL finished on a high note after plunging 45% in the wake of Jamal Khashoggi’s Oct 2018 murder (when the US achieved maximum leverage over the Saudis – see: Coincidences and Consequences.) The last significant bounce accommodated both the Aramco IPO and the year-end equity ramp.
Oil has been a favorite tool of not only the Saudis but also central bankers and politicians. In fact, understanding the relationship between oil/gas and inflation, interest rates and equity valuations has made it possible to accurately forecast most of its major moves over the years.
At times, this has meant ignoring the frequently misleading supply/demand data, OPEC deliberations, and presidential tweets and focusing instead on where central bankers needed oil/gas to go in order to achieve a particular inflation and interest rate goals.
As interest rates rose over the past few years, for instance, it became obvious that inflation would need to moderate to relieve the building budgetary pressure.
One major theme on which we’ve focused since calling the top on interest rates in October 2018 [see: Suddenly Interest Rates Matter] has been the relationship between CPI and the YoY delta in gas prices. By “managing” the price of RBOB, CPI and, thus, interest rates could be managed higher or lower as needed.
This was a very reliable theme for most of 2018, 2019, and early 2020 – when the focus shifted to oil’s strong correlation to stock prices.
Oil has long been a major factor in triggering algos to bid up stocks. So, when oil’s major channel from 2016 broke down in February, we knew stocks were in deep trouble.
With CL dropping through its 2001 lows and approaching its 1998 lows, what might we expect from oil and what are the implications for stocks? As we discussed last week:
A drop through 19.27 would be reason enough to revert to short with 17.12 and 10.65 the only support between here and zero.
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Many seasoned investors are surprised to see how positively correlated stock returns have been to oil prices. Energy stocks make up 8% of the overall market, so you’d expect them to have some influence. But, thanks to the increasing prominence of algorithms and quantitative trading, the impact has grown well beyond what 8% should contribute – with most of the market’s significant highs and lows perfectly aligned with oil’s over the years.
A 2017 study by JP Morgan estimated that only 10% of trading volume is by discretionary investors who focus on fundamentals. This means that 90% of all volume is driven by passive and quantitative techniques including everything from index funds and ETFs to high-frequency trading and corporate buybacks.
The tail that wags the quantitative dog is algorithmic trading, where hundreds or even thousands of factors are constantly monitored and provide instant input for trading decisions. While these factors include big picture economic data such as interest rates, inflation or employment figures, the Big Three that consistently drive big moves on a daily basis are VIX, the USDJPY and the price of oil – specifically WTI futures [CL.]
Oil is the only one of the Big Three which has an almost immediate and substantial impact on the US economy. So, when prices are manipulated higher or lower, we see a change in inflation data, interest rates and, of course, stock prices.
This is why we were able to call the top on October 3, 2018:
CL and RB…not only reached overhead resistance by our measure, but must deal with inflation that’s too high, bearish API data, another round of Trump tweeting, and a large build in EIA inventory. I think the time has finally come to revert to short…
CPI had recently reached almost 3%, dragging interest rates higher as well. The 10-YR reached 3.25% on Oct 5, threatening to break out of a channel dating back over 20 years at a time when debt was exploding higher.
Trump had been jawboning and tweeting his desire for lower oil prices. But, his entreaties had fallen on deaf ears until Oct 3, when journalist Jamal Khashoggi was brutally murdered and dismembered by agents of Saudi Arabia for criticizing Saudi Crown Prince Mohammad Bin Salman (MBS.)
As details emerged and MBS’ complicity became evident, Saudi Arabia suddenly needed friends in high places. Trump was happy to oblige, but had one condition: oil prices needed to decline immediately – which they did. CL plunged 45% over the next 11 weeks.
The YoY drop in oil and gas prices was immediately reflected in inflation. CPI dropped from 2.52% in October to 2.18% in November and a low of 1.52% by February 2019.
The 10-YR dropped from 3.25% in October 2018 to 2.36% by March 2019. Prices at the pump plunged as well, and Americans rejoiced at more affordable commuting costs.
Remember, oil is one of the Big Three drivers of stock prices. So stocks plunged as well – shedding about 20% by December, when Treasury Secretary Mnuchin convened the Plunge Protection Team to prop up the market – enabling stocks to reach new highs while CL merely enjoyed an extended bounce.
Saudi Arabia needed the bounce every bit as much as did stocks. The troubled Aramco share offering had been delayed time and again, and higher oil prices made a larger raise possible. The plunge resumed within a few weeks of the IPO.
Then came the slowdown. Demand had already been ebbing and prices had been settling lower for weeks. But, after a very brief bounce, oil prices plunged when COVID-19 came onto the scene. Suddenly, fundamentals mattered again.
Prices plunged to the bottom of a falling channel from 2008 over 3 years ahead of schedule per the cycle study we first posted in March 2019 [see: Macro Cycles and Regime Shifts.]
This added fuel to the fire for stocks, which already had plenty of reason to plunge as global economic activity screeched to a halt. Algos, which might normally have been employed to prop up stocks, were pressuring them lower. At the same time, the USDJPY was falling as the Japanese yen rallied and VIX spiked higher on greatly increased volatility.
Note that long-term trends in gasoline prices were also in danger of breaking down.
Perhaps more alarming to Team Trump, the Dow had fallen to levels not seen since the 2016 election. 
The energy industry is vitally important to the US, with millions of jobs and billions in loans dependent on prices stabilizing. It’s no surprise that the federal government would support it as it has many other industries which have been decimated by the global pandemic. Many majors oppose price supports, perhaps hoping to scoop up highly-leveraged players at a bargain price when they failed.
However, instead of making low or no-interest loans available to tide the industry over as it has with every other affected industry, Trump has focused on artificially inflating prices — first with a series of Tweets and lately with a threat to impose tariffs on imported oil.
As a result, oil has spiked over 50% higher in a mere 4 sessions…
…facilitating a 24% bounce in the Dow.
While some are thrilled with the outcome, there are winners and losers. The biggest losers are those who can least afford it: consumers. Higher oil and gas prices are a regressive tax on those consumers who must still drive (disproportionately those less affluent) or buy heating oil or natural gas to keep their families warm during the waning days of cold weather.
It’s important to recognize that Trump’s insistence on higher oil prices might be partly about saving oil industry jobs, but it’s really about saving the stock market which has learned to take its cues from oil prices.
If Trump’s “friend” Mohammad Bin Salman — a “man of the people” — still owes any chits from 2018, oil prices could be well supported going forward. But, of course, it will require the assistance of Trump’s other friend, Vladimir Putin, whose willingness to cut back production involves slightly different priorities.
With COVID-19 deaths in the US topping 10,000, Putin’s response will be important in crafting the next headline-stealing development. But, most studies I’ve seen indicate that supply now exceeds demand by at least 25 million bpd. So, even the 10-15 million cut suggested by Trump would do nothing to erase the massive oversupply but would merely slow the rate at which the excess is building.
Rumor has it that Russia will play ball as long as every other oil producing nation is willing to share the pain – including US shale producers, many of were already on life support before COVID-19 (and expect a decent return on their political donations.)
If I sell you 100 barrels at $30 instead of 200 at $15, have I made any more money? Will I now be able to pay back that overdue loan? Will the market reward my stock? Unfortunately, it only works if the pain is borne by the other guys — which will likely boil down to good, old-fashioned horse trading. Trump’s opening ante is throwing down-and-out Americans under the bus. We’ll see if it’s enough.
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Once upon a time, a few boys whose families owned the biggest lemon groves in town got together and opened up a lemonade stand. It was a very hot summer, so they sold an enormous amount of ice-cold lemonade. Since they controlled the supply of lemons, they were able to quickly raise prices from 10 cents per glass to as much as $1.50. Their customers didn’t mind as they could afford 1.50, it was excellent lemonade, and there were no alternatives. They like it so much, in fact, they invested $2 trillion in shares of the stand.
One day a freak storm hit town, and the temperature dropped from 95 to 25 degrees in a matter of hours. The weatherman said it could last for months. Not many people were interested in ice-cold lemonade, even though the boys frantically dropped their prices. They even tried cutting back on the amount of lemonade they made. For some reason, this had no effect on sales, and prices continued to drop. A few boys split away from the group and tried selling cheaper lemonade on their own, but this further depressed prices. Soon, the lemonade stand went out of business. The end.
And that, boys and girls, is how OPEC came to be in their current predicament.
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We start this morning’s post with a peek at the Russell 2000 as it perfectly illustrates the dilemma facing the broader markets this morning.
Up until September 2017, RUT followed a well-defined rising channel shown below in yellow. Like all channels, it was defined by the tops and bottoms along the way. The only problem: The channel was rising only about 5% per year – hardly enough to get excited about.
By late 2016, it had become obvious that algos had more influence than discretionary, fundamentally-oriented investors. The algos were, in turn, influenced by certain factors which central banks and their proxies could usually control quite easily. By wagging the tail (the factors) the whole dog (the market) would usually fall in line.
In September 2017, after RUT had been bumping up against the top of the rising yellow channel for over 9 months, the factors went to work and RUT broke out of the yellow channel and rose 21% over the next year. The slope of the new rising white channel was good for about 20% per year.
Everything was going well until September 2018 when RUT topped out at 1742 and plunged 27% in only three months. To make matters worse, the new rising white channel broke down and RUT fell back below the top of the yellow channel from which it had broken out.
It spent the better part of the next year trying to break out of the yellow channel again – failing seven times until Dec 4, 2019, when it finally shot above the channel top and remained there. There was a scare last month when, on Jan 31, it successfully backtested the channel top and bounced 5.5%.
Given yesterday’s carnage, though, it has fallen back to the top of the yellow channel where it faces that same important test all over again. If it holds, all is well and investors can go back to mindless trend following.
Even if it doesn’t, the SMA200 is now up to 1574, a modest 3.3% below yesterday’s close. But dropping through 1616ish would mean breaking down below the horizontal support (which served as overhead resistance between Oct 2018 and Dec 2019.) It could accelerate losses and complicate the rescue mission.
RUT is typical of many of the indices and individual equities I chart every day. The Dow, for instance, faces a similar test at 27,700.
And, SPX and ES completed important backtests (the purple channel top below) in the process of tagging our next downside targets yesterday.
Given the way the factors are behaving this morning, there is a good possibility that we’ll see additional backtest targets such as DJIA 27,700 tested today. But, that would mean taking a chance on the algos’ ability to rescue stocks from some very risky waters.
Stay tuned.
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Futures are higher this morning on what is expected to be a non-event FOMC announcement and press conference. 
I suspect attention will again return to currencies, as the US dollar’s surge over the past month, combined with the big drop we had anticipated in oil and gas, will serve to tamp down inflation fears. Of course, there’s a fine line between falling inflation fears and growing deflation fears.
The bond market continues to reinforce the bearish case for stocks.
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We’ve been bearish on oil for quite a while, shorting it at 75.57 on October 3, 2018 after Jamal Khashoggi was dismembered and at each of the 3 subsequent peaks since then: just before the JCPOA breakup, the Abqaiq attack and the Aramco IPO — which should have been a peak, but resulted in a headfake “breakout” climaxing in the Al Asad attack.
Last night, CL dipped to within 0.41 and RB within 0.187 of our next downside targets. 
As members know, these are critical support levels. A breakdown would be devastating to oil and gas and present stocks with very strong headwinds.
Futures, now at 3260, are headed straight for our next downside target at 3200.
Yes, the coronavirus is potentially a very big deal. But, this decline in oil and gas was baked into the markets over a year ago and is a strong endorsement for our inflation model.
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WTI futures spiked nearly 5% overnight in the wake of a US drone strike on Baghdad Airport which killed Iranian military commander Qasem Soleimani. It is a dangerous escalation in the US conflict with Iran which broadened when Trump alarmed US allies by pulling out of the Iran nuclear deal last May.
We argued at the time, as did many, that Trump’s actions put the US on the path to a potential shooting war. The assassination of Soleimani clearly amplifies the risks. So far, oil prices have pushed only slightly above the levels reached after the nuclear deal pullout and the Saudi Aramco plant was attacked in September. But, this is obviously a more serious geopolitical development. 
From an economic standpoint, a sharp rise in the price of oil further complicates the already thorny inflation problem facing markets – setting up a showdown between Fed hawks and doves in January.
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The markets weren’t exactly reassured by Powell’s testimony yesterday. Bottom line, no one in their right mind buys the idea that we can have such strong GDP and wage growth but still need such accommodative policy. IMO, Powell was curt and sometimes downright evasive, which didn’t help matters.
Stocks plunged to our initial downside target, closing well below the SMA10 (a rarity, lately) with additional downside potential this morning.
AAPL tested its channel top and retreated. As we discussed yesterday, this failure to break out has weighed on the overall market.
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