The price of oil (West Texas) dropped nearly $3 and hit it’s lowest level since the 2nd half of 2010. It’s dropped 31% since July. The explanations being promoted by the mainstream blogosphere for the price decline is either 1) the U.S. has manipulated the price lower to punish Putin/Russia or 2) the Saudis have flooded the market with supply to drive U.S. oil shale/fracking out of business.
Both of those rationales are nonsense. Too be sure, I have no doubt whatsoever that the price of oil can be teased lower by manipulative activities. But for the reasons below, I believe that the price of oil can be driven lower for only a very short period, especially if global demand requires at least as much oil as is profitably being produced.
First, it is more difficult to drive the price of oil lower using futures – as is done with gold/silver – because oil is a depletable commodity and the entity shorting paper oil risks the probability that the long side will ask for actual physical deliver. Second, IF the price of oil were being manipulated lower using artificial mechanisms, sophisticated oil traders – Wall Street banks, big hedge funds, sovereign funds and oil companies – would buy up this supply and store the oil until the price bounced back. It’s an asymmetry of information arbitrage play, if you will, and sophisticated entities have superior information to the market in this regard. Also, please note that several banks have invested in oil storage terminals for this purpose. Third, I find it very hard to believe that greedy multi-national oil companies would agree to piss off Putin at the expense of profits. And, by the way, Russia is clearly not hurting given that it bought 37 tonnes of gold with cash in October.
Instead, the plunge in the price of oil reflects the collapsing global economy, which – by the way – includes the U.S. economy:
I wrote an article in October which outlined why I thought the U.S. economy hit a wall in the middle of the summer.
To summarize: 1) weekly and monthly nominal retail sales reports started showing declines. This is highly unusually because typically retail sales always increase at least by the rate of inflation. Negative retail sales reflect a decline in unit volume, which means consumers are buying less. McDonalds reported sales declines 12 months in a row, for instance.
2) Housing sales have been comp’ing year over year negatively for the past year and prices are starting to decline. This is especially true when you strip away the National Association of Realtor and Census Bureau “seasonal adjustments” and you just compare year over year for each month. The fact that both entities report their results stated in an “annualized rate” only serves to compound the statistical errors embedded into the numbers by the preposterous “adjustments.”
3) In general, the various macro/regional economic reports from manufacturing organizations, regional Fed banks and even the Government have been showing declining industrial activity. This too is in spite of “seasonal adjustments” tortured into the data.
The red line in the oil price chart above shows where I believe that the price of oil began to anticipate and reflect this sudden rate of decline in the U.S./global economy. The drop in the price of oil reflects a demand-side shock – a lower rate of economic activity globally drives the demand for energy/gasoline lower relative to supply and the price drops. Thus, a plunging price of oil reflects a plunging economy. It’s really that simple – just ask the Democrats.
Now, what does this mean for the U.S. stock market. The U.S. stock market has levitated higher on a flood of printed dollars and the multiplier effect created by the magic of a fractional banking and securities mechanism. Through the magic of reserve ratio leverage, every dollar printed and given to the banks transmits into several dollars that can pile into the stock market via the banks themselves and through the use of hedge funds – which are extended up to 10:1 leverage from banks – as a transmission mechanism. Unless the Fed is clandestinely printing at least the same amount of money that it had been printing, that game is over now.
(click on the graph to enlarge) The graph above is a 1-yr daily of the S&P 500. As you can see, for the last year, every time the SPX extends above the 50 dma (blue line) it tends to correct below the blue line. This tendency actually goes back for three years. The latest iteration higher has occurred on noticeably declining volume. The SPX has also closed higher a preposterous 15 of the last 21 days, including 6 of the last 7. On several of those 15 days, the SPX was down for the day going into the last 30 minutes of trading and, “miraculously,” would manage to rally into new high territory by the close. Today ia a perfect example of that, as it was red even within the last 10 minutes before the close (futures basis) before squeaking out a small gain for the day. The futures turned red again right after the close.
In addition, notice that the RSI (yellow circle) has now rolled over from an extreme overbought condition. And the MACD is now rolling over from its most overbought level in the last year. The MACD is a slower moving statistical indicator than the RSI, which means a change in directional trend is a better directional indicator than the RSI. The MACD is suggesting that the SPX has a high probability of rolling over here.
This is in the context of this stock market being the most over-valued in history (see this LINK) and in the face deteriorating economic fundamentals. I have pointed out to colleagues that, on an “apples to apples GAAP accounting basis,” the current stock market is far more overvalued than it was in 2000. Since 2001, the FASB has changed accounting standards in a way that makes it much easier for companies to report much higher non-cash GAAP accounting profits than they were able to manipulate into their GAAP net income in 2000.
One more chart that should freak out:
The graph above shows one of the Pimco commodity funds vs. the S&P 500 for the last 10 years. As you can see, before QE started, these two indices were highly correlated. The divergence of the S&P 500 from the Pimco fund reflects the degree that QE has influenced the market. I my view, there will be a very painful “regression to the mean” adjustment that will re-establish the correlation between the commodities market and the stock market. This mean-reversion will occur without the commodities market moving higher…
Given the remarkable degree of official intervention in all of the markets, but especially in the stock market (and of course the gold/silver market), I’m not going to stick my neck out and say the stock market is headed for a plunge, although I think this is a very distinct possibility. I will say that anyone at the retail level chasing this market is an idiot and any institutional money manager not pulling money out of the stock market right now is guilty of breaching fiduciary duty. And with the stock market’s “theater” full from wall to wall, including those taking up standing room only space, and with only one door leading to the exit, when the fire does start it’s going to look like Biblical Armageddon in that graph above.