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.

Most technical analyst junkies are already familiar with the percentage of stocks above moving averages. This is where we look at the percentage of stocks within a group that closed above a certain moving average.

The shorter the moving average, the more short term the significance of the signal. Although, Lowry’s has intriguing research which shows that very short term measures (10 day moving average) can indeed be a sign for more long term signals as well.

Rather than look at this indicator as most do, I give it a twist by calculating a ratio between the medium term and the long term. That is I take the percentage of stocks in the S&P 500 trading above their 200 day moving average and I divide them by the same for the 50 day moving average.

Why do that? Well, for one it gives me something which few look at. And for another, it easily identifies instances where although the long term market was healthy (generally trading above the 200 day moving average), there was a short term correction.

This is ultimately what we want. That the major uptrend be intact and to buy a short term correction within that uptrend.

Right now, 47.8% of stocks in the S&P 500 are trading above their 200 day moving average. While that is quite low, it did get as low as 40% in the summer of 2004. Along with 18% being above their 50 day moving average, this gives us a ratio of 2.66 (see chart).

That spike you see in the chart below, like all previous spikes, is a bullish omen:

The only negative that I can find for this type of indicator is that the other market proxies aren’t as extreme. For example, among the major indices, the Nasdaq 100 Index (NDX) is currently showing the highest percentage of stocks above 50 day moving (at 39%). The S&P 100 is at 22%. I’d prefer to see readings closer to 20% myself but we never have all the stars align perfectly.

And you can’t argue with the largest and most significant index (S&P 500) showing only 18% of its constituents trading above their 50 day moving average. This is the level at which all our inflection points have arrived at since the bull market began in 2002.

The only time things got hairy was at the bottom of the 2002 bear market when it reached the dreaded 0%. That is zero stocks trading above their 50 day moving average!

I think everyone woud agree however that we are not in the same environment (fundamentally, technically and sentiment wise) as we were back then. So I put the probability of that happening as extremely small.