Trader’s Narrative

Yesterday Bill asked me to take a look at the crude oil market. So here is a quick overview of what I think is going on.

Here is a long term chart of the price of crude oil along with its distance from the 200 day moving average:

OPEC Tax
The price of oil, above a certain point, becomes a tax on western economies. The higher it goes, the less will be consumed and the less economic growth we’ll have. One of the reasons we had an amazingly powerful economy between 1998-2000 was that oil fell to single digits. So there is a built in mechanism in place to moderate price but due to structural reasons it doesn’t work with instantaneous or perfect regularity.

Indexing Fever
The recent parabolic rise may be explained by something other than a supply demand imbalance. In the past few years we’ve seen a trend towards commodity index funds which creates a positive feedback loop. The better the performance of commodity markets, the more funds are allocated to it by pension funds, hedge funds, and other institutions.

And we’re talking about billions and billions of money. And it is flowing to long only strategies. Just buy, and buy some more! It is somewhat similar to the hyper indexing phenomena we saw happening in the tech bubble years. As the Nasdaq 100 index went sky high, it attracted a lot of hot money who would buy ETFs or index mutual funds to chase performance. This would then propel the index higher as these funds would create new baskets to put this money to work in the market. So a positive feedback loop legitimized itself through self-created performance:

Source: It Takes Crude To Contango by Howard Simons at thestreet.com

The problem with a scenario like this is that it becomes increasingly difficult to call an exhaustion point. You can easily be steamrolled flat by the tremendously robust trend. Believe me, many very smart and well capitalized traders were flattened trying to short the internet bubble stocks. The trend will last until it doesn’t. That’s about as lucid an explanation as you can get.

Contango
The normal situation when the price of oil is rising is for future prices to be lower than spot prices. This is called backwardation. But right now the oil market is in contango - where future prices are higher. This is a rare occurrence which creates incentives for speculators to purchase oil, take it off the market, store it and then sell it at some point in the future to gain arbitrage profits.

So now we have speculators who are piggybacking on the commodity indexing trend, pushing it even further, as well as buying contracts in an attempt to “front run” the inevitable buy orders coming down the pipeline.

Flying Turkeys
All of this is happening in the derivatives markets and it is rather complicated for most people to wrap their minds around. Here’s a simple sign of froth in the oil market which most people can identify much easier. We are seeing small, extremely speculative stocks in the energy sector fly off into the stratosphere. For a quick example, take a look at the charts for Pyramid Oil Corp. (PDO) and MEXCO Energy Corp. (MXC).

Most of the stock spam is now pumping oil, gas and energy related over the counter penny stocks. This is the last stage of a parabolic blow-off. When the lamest and sickest of turkeys start to fly as if they were hawks. But good luck in actually pin pointing the top.

The magazine cover indicator is a great contrarian sentiment measure because once a topic has reached massive public penetration and put on the front cover of a magazine, the trend is about to finish.

But once in a while we get conflicting covers. And in such a case, the question then is, which one is right? which one do we fade?

A recent example is the cover of Time and the Economist in the summer of 2005. They both came out within days of each other and had very different views of the housing market:

After the Fall
The symbolism of the brick in free fall left no doubt what stance The Economist was taking on this issue. Although housing prices were going up like there was no tomorrow, the Economist was asking about what would happen after the inevitable fall.

I remember reading this while in Europe because I could see first hand the freakish gains in real estate and the avarice that it had fueled over there. Published: June 18th, 2005

Home $weet Home
Now contrast that with the cover on Time showing a man happily squeezing a house in a bear hug. Note the $ instead of “S”weet and the taglines: We’re going gaga over real estate, Will your house make you rich?, Super hot markets, It is time to buy-or sell?, The case for renting.
Published: June 13th, 2005

For some perspective, here’s a chart of the housing bubble (superimposed on that of the internet bubble gone by):

Source: InvesTech’s Housing Index is proprietary composite of the most sensitive stocks in the housing sector.

So which one of those covers should you have listened to?

Obviously The Economist. I myself tried in vain to point out the danger of such a hyper-inflated bubble to a relative who was heavily invested in European real estate. I was given a laundry list of why the argument in the Economist article didn’t matter or was wrong.

But why?

Not because one magazine is inherently better but because one magazine (Time) is geared to a more general audience while the other (The Economist) is targeting a very discerning readership. Plus, if you had read both articles, you couldn’t have noticed that Time’s was simply “fluff” while the Economist one was bursting at the seams with data and more data.

My point is this: to get a really good contrarian cover indicator, look for the most general audience publisher. Don’t go for specialty publications.

The full Economist article (minus tables and graphs) after the jump:

Continue reading ‘When Magazine Cover Indicators Clash’

Last Thursday, Barry Ritholtz wrote in The Big Picture about two data points sent in by Doug Kass:

• The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

• Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

While Kass is a blisteringly smart guy, his penchant for the bearish side is well known. So to balance things out a bit I’d like to offer a few counter points delivered by Jason Goepfert from SentimenTrader.com

Mutual Fund Cash Positions
Since Goepfert won the 2004 Charles H. Dow award for his paper on mutual fund cash levels, he is a real authority on this topic. To read it, click on the Dow Award folder within the free trading resource box.

According to the paper, we have to normalize the mutual fund cash levels to account for varying interest rates over time. When interest rates are high, mutual fund managers have an incentive to maintain high cash levels because they are compensated for it. So Goepfert models the theoretical cash level for every interest rate point.

However, having normalized cash levels we still find that right now, mutual fund managers are holding about 3.38% less cash than they should be (theoretically for this interest rate level). It may not be that bearish though. For one, if we see a reduction in the Fed rate, it will reset this indicator. Also, a low cash level can be explained by structural changes in the mutual fund industry.

As indexing has grown, it has taken a larger and larger percentage of assets. Since by definition an index can not hold any cash, this can skew the data. But in reality it only reflects a trend towards indexing (and closet indexing).

Another possible explanation is that charters for mutual funds only allow the manager to hold a certain level of cash and in essence, forces them to invest the rest in equities. As well, with the implementation of new technologies, asset managers can now see fund flows in almost real time, allowing them to react quickly to redemptions and not requiring them to have a cash cushion.

To be totally honest though, while valid, these alternative explanations are rather weak. This indicator is quite accurate in the long term and because of that, it does bother me when I see it at such extreme. What Goepfert argues is that it may not be as extreme as it looks.

Margin Debt
When NYSE margin debt overtook the 2000 levels, many bears made a huge deal out of it. However, this data point must not be taken so superficially.

Goepfert points out a little known statistic: apparently the NYSE not only keeps track of how much margin is being used within brokerage accounts but also how much available cash is there. It is important to note that these cash levels exclude the cash generated by short sales - so what is reported is cash that is owned, unrestricted by the account holder.

Interestingly, when we look at cash level, we see that, as a percentage of market capitalization, it is around 16% now. That’s double from 8% at the 2000 bubble top.

The point is that while margin debt relative to market capitalization is high now, investment account holders have in fact much more cash than they did during the top. This represents a huge amount of real buying power that can drive the market much higher as the cash is put to use.

That potential buying power simply was not there seven years ago.

Classic
This is classic Goepfert. He takes what is seemingly obvious, drills to the core, brings data and hard facts to bear and serves up real insight. Most people start out with a conclusion that ‘feels right’ and cling to the factoids that support their position.

I didn’t reproduce the graphs he provides but they are a thing of beauty. To see them, take a 14 day free trial. Trust me, you’ll stick around on day 15.

It doesn’t matter if you’re daytrading or watching the grass grow on your 401k, as long as you’re serious about making money in the market, Jason’s insights are a must.