Trader’s Narrative

The last time I revisited the Chinese stock market, it was in the throes of a major bear market. Fast forwarding to now shows things have only intensified with the Shanghai composite trading at less than half of its top in October 2007:

While we quibble about a percentage point here and there to see if our market decline fits into the classic definition of a bear market, there are no qualms regarding that in China.

Support?
The scary thing is that even after falling so much, the index is still far from major support areas. If you look at the link above, you’ll see a long term chart of the Shanghai composite going back to its founding. According to that chart, significant support is somewhere in the vicinity of the 2000 level. That would put a potential fall to almost 70%!

I have no idea if that will happen but the Chinese stock market certainly has precedent. It is not for the faint of heart. The Shanghai Composite can go ballistic: rising as it going ten fold in the span of a year (1991-1992) but it can also lapse into deep stagnation, as it did from 2000 to 2007, treading sideways.

Dire Portents
But what interests me more is the portent of such a dramatic decline for the price of crude oil. From what I read, China holds significant responsibility for the current price of oil because of its voracious appetite. But if the stock market is a forward discounting mechanism, that means that the Chinese economy is about to decelerate or even go into a tailspin.

The corollary of that is lower demand for oil and, if I remember Economics 101 correctly, that would mean a lower oil price - all things being equal.

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.