crude oil redux

Two weeks ago I highlighted the New York times headline on crude oil prices. Crude prices have moved up about five dollars a barrel since then. Above this post you will find two more pieces of evidence for what I see as a bullish investment crowd in crude oil.

The first image is of the latest cover of The Economist. It tells us that crude oil prices have lit the fuse of a bomb which will destroy the worldwide economic recovery.

The second image is of the front page of today's Chicago Tribune. It speaks for itself.

At the top of this post is a monthly chart of West Texas crude oil prices. The market is still trading well shy of its 2008 high of $147. But it is also up 300% from the $35 low of late 2008 and has been moving steadily higher for more than two years.

I think that while prices will probably move higher from here, maybe to $112 or so, the next big swing in crude oil prices will be downward.

crude oil

Things have been pretty quiet on newspaper front pages and on magazine covers over the past few months. But this morning the New York Times headline concerned the oil market (image at top of this post).

The headline itself is emotionally very restrained. However, I do think that the two year rally from the December 2008 low at $35 has built up a substantial bullish investment crowd in the oil market. People keep telling me that oil can only go up from here because of inflation, and improving world economy, etc.

But oil is a commodity like other commodities, and it has a substitute for many bulk uses - natural gas. Natural gas prices are near historically low levels and I think this is not only going to keep a lid on oil prices but will also soon be exerting substantial downward pressure on the crude market.

Political uncertainties may well drive crude a little higher, say into the 100-105 range. But once the psychological $100 barrier is breached I think sellers will come out in droves. Within a couple of years crude oil should be selling below $50.

QE2

I have been reading a lot of nonsense about the effects of the Fed's policy of quantitative easing (QE2). Here is my e-mail response to a friend who asked me about this:

Catherine:

I think Bernanke did exactly the right thing when he pushed the Fed into QE2. Moreover, at least so far, QE2 is a success. How do I know? First, the dollar index is going down (and I think it has a good shot at 65 - but when QE stops the dollar will rally, and rally big time). Second, the yield on the US 10 year is going up while the tips spreads are pretty much unchanged. This shows the bond market is expecting more economic growth, not more inflation. Third, the US stock market is going up, also reflecting expectations of higher growth.

QE works by inflating asset prices (stocks, commodities, real estate and other real assets) which rise initially because investors re-balance their portfolios after they sell assets to the Fed. But rising asset prices encourage their production (real investment) and also make people more optimistic about the future (more bullish "animal spirits" to borrow Keynes' phrase). These last two effects boost economic growth if there is slack in the economy as there is now.

Carl

back to normal long positions

As you can see from the daily bar chart above the cash S&P 500 has reached new highs for the bull market that started in March 2009 from the 666 level.

The aggressive contrarian trader has maintained an above average long position established at the 690 level. According to the rules set out in chapter 11 of my book the aggressive contrarian should have sold his long position when the 50 day moving average of the S&P turned lower by 1/2 % in mid-May of 2010. But by then the S&P itself was in a position where I thought the aggressive contrarian should be a buyer. I said so in this post and again in this one. So the net result was that the aggressive contrarian would have held his above average long position throughout the April-July 2010 drop.

Now that the S&P is back at new bull market highs and has rallied more than 20% from its early July low I think the aggressive contrarian should cut back his above average long position to average levels. I would not reduce exposure more than this because I think that the S&P has quite a bit further to go on the upside over the next six months.

The conservative contrarian established an above average long position around the S&P 1000 level as I pointed out in this post. As I write this the S&P has rallied for 20 months from its March 2009 low and has advanced 82% during that time. According to my tabulations (which were described in my book) this qualifies as a normal bull market both in duration and in extent. So the conservative contrarian should now reduce his stock market exposure to normal levels too.

bond frenzy redux

Yesterday the Federal Reserve announced its latest program of "quantitative easing", a program that had been well anticipated by the stock and bond markets. The Fed is going to be a big buyer of treasury bonds and notes over the next 12 months. Today's front page of the New York Times has as its headline story the Fed announcement.

As I pointed out in my last post on this subject a couple of weeks ago, the bond market is in a "frenzy" stage. The chart above shows that 10 year note yields are near their historical low points. In fact,the last two front page stories on the bond market have both occurred while the 10 year note yield has hovered above its recent lows and above its historical low of 2.02% reached in December 2008.

I take this as evidence that the market thinks the Fed will succeed in its goal of fostering an economic recovery. The implication is that bond yields are headed much higher from here.

Interest rates headed up

Just above this post you see an image of the October 26, 2010 edition of the New York Times. Just above the fold on the left side of the page you will find the heading "Bond Frenzy: Investors bet on inflation". The NYT reports that in the latest auction of 5 year, inflation protected, treasury notes investors paid the treasury 55 basis points per year for the privilege of loaning the treasury money!

According to the Times the auction results tell us that investors fear inflation but I do not agree. If they did ordinary, non-inflation protected note yields would be high. But as you can see from the top chart of weekly 10 year note yields this is not the case. In fact, the yield on 10 year treasury notes is very near historically low levels. A different way to see this is to compare the inflation protected yield with the yield on ordinary 5 year notes. This spread, currently less than 2.00%, is the market's best estimate of likely annual inflation for the next five years. No expectation of inflation there!

But as a contrarian I think the NYT use of the term frenzy to describe bond investors' mass behavior is spot on. In this previous post I observed that mutual fund investors were pouring money into bond market mutual funds and taking it out of stock market mutual funds at a record pace. That hasn't changed during the past couple of months. Nowadays people brag about their bond portfolios like they used to brag about the skyrocketing value of their homes or the pile of money they made on the latest dot.com offering.

Nearly two years ago I predicted that the bull market in bonds and the long drop in yields that began in 1981 was just about over. I haven't changed my mind. And the prospect of further quantitative easing by the Fed just reinforces my view. Bond yields are heading much higher from here.

The Worst is Over

At the top of this post is an image of the cover of the latest issue of Time Magazine. The chart below the Time cover is a monthly chart of the housing stock index quoted on the Philadelphia stock exchange.

The historical low of the index was reached in March 2009, coincident with the low in the S&P 500. While the S&P 500 is currently trading about 30% below its all time high, the housing index stands 70% below its all time high and much closer to its all time low than the S&P.

The Time cover together with the fact that the housing index is still near the low of its historical range suggests to me that the worst is over for housing stocks. I doubt we shall see a return to all time highs in the index any time soon, but neither do I think the 2009 low will be taken out.

The important point here is that if the housing market in the U.S. can stabilize and recover, then the entire economy will get an extra upward push. This in turn will help lift the gloom that seems to have engulfed the the U.S.A. As the dark clouds begin to disperse the stock market will rally. I still think the S&P 500 is headed for 1300 and above over the next nine months.