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8 reasons to avoid the market

Normally, I prefer to tell a story with pictures, but I’m going to try something different and bullet out 8 top of mind reasons to avoid the market. Each one could be its own blog post. Comment if want me to elaborate on any.

  1. Coronavirus: This should be obvious; we have a market down only 5% YTD and the best performing index in the entire world despite the highest number of deaths. Large chunks of the economy are still shutdown, and with no clear entrance plan, there is no clear exit plan. Is there really no probability of it surging again, no probability of higher taxes, etc?
  2. Riots: Somehow the market rose today despite riots breaking out across the country. While my primary focus is on finance, I have for years studied global peace movements (my minor in college). One thing I know from all the literature and case studies – when protests intersect with force, the situation can spiral. Now, maybe this is not a high probability event (I don’t know; it looks scary), but the probability has risen. Yet the market was up today.
  3. The overall market volatility has been low. However, if we look at upticks vs. downticks intraday volatility, there is clearly tension; it’s like pulling on strings. I believe there are quantitative models (CTA’s, etc.) who are buying equities on dips. They lever up intraday (sometimes as much as 15x!) to mean-revert securities and markets. It leads to a lack of price discovery and creates tail risk.
  4. Consumer is still under extreme pressure. Leverage has risen. Businesses are closed in large parts of the country, and there has likely been a permanent change in behavior (e.g. will people really eat out as much in the future?). Again, consumer is 70% of the economy.
  5. Oil has been forgotten since it bounced back from negative territory, but $35/barrel still leads to significant pressure for E&P companies; many will not survive. This bounce just extends the inevitable.
  6. Manufacturing is still extraordinarily weak. China had a false start in their Purchasing Managers Index, which has since faltered.
  7. There are wild misconceptions about how if there is monetary activity, it props up assets, and you just buy the dip. Cycles are smoothed with strong monetary policy; they come at the expense of the future (it’s like personally borrowing to smooth through a rough patch). Smoothing a global economic collapse is a different story.
  8. There is too much money in the system. What this whole market action tells me is there is simply too much capital floating around with no place to go. So people revert to buying up equities. Step back, think about it – could you imagine a worse situation for the global economy and stock market back in December of last year? It’s a complete global halt, deaths, people in lockdown. Yet the market is down 5%; that seems disconnected from fundamental reality.

In conclusion, to me, there is bubble risk. When will it burst? What’s the trigger? Hard questions; no good answers. But I think if this real economic pressure continues, there will be forced liquidations on college endowments, pensions, personal retirement accounts, etc. This can counteract the CTA and quant buying activity described in number 3 above. And when they lose, with that kind of leverage, they can shrink rapidly and become less active in the market, unable to prop it up. So maybe that’s a trigger for the domino effect. But I wouldn’t touch a market shrugging off anything after a half an hour of incremental newsflow.

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It is unlikely we run out of oil storage capacity but that is not the point

Summary

I’ve received a few questions offline from people noting they have seen headlines of energy producers reducing their capital expenditures (capex) or cutting them entirely in response to the lower prices, and wondering whether or not that is sufficient to balance the market, and if so, wondering if that means the coast is clear.

Oil markets are complex, and we’d need need pages to properly answer this good question. But we’re not making an oil call here. What we’re saying is A) cuts thus far have been insufficient for a decline in oil production; B) companies losing money and facing ballooning debt with breakeven economics well above current levels will not necessarily proactively cut their production as that would ensure their demise; they will act as options and hope for a turn, which when not achieved, may force them to shutter; we have not seen that; (C) When that happens, the market will rebalance, and that does not mean things are okay; what it means is that supply finally fell in response to a 30% demand decline (supply and demand rebalanced the hard way). We will then start to see the knock-on implications for other companies indirectly linked to oil, and it will likely not be benign. That’s the main point.

Oh, and along the way, we will not likely face a storage shortage because there will be a (painful) response. But that’s a distraction – the main point from the previous post, is that oil drives a significant portion of the US and without an active consumer, there is no offset to this massive pressure.

Observations and details

  1. Capex cuts are misleading: Headlines abound of energy companies slashing capex. This is misleading for a few reasons: (A) Energy companies have cut capex for years while growing production (capex fell 21% from 2010 to 2018 while production doubled). This is possible due to movement to new formations and horizontal drilling. Beyond our scope, see here for more info. (B) Energy companies already had a decline of 13% at the beginning of the year in 2020 capex vs. 2019; we are now at 22%, so it’s a 9 percentage point increase in the cut, not a fresh 22% cut; (C) There is sustaining capex and growth capex; sustaining capex is the capex to sustain the existing production; growth is investment to expand it. Much of the incremental cuts have been to growth projects, not existing production (perhaps I’ll break this out in a separate post); (D) The big boys, who are better positioned, have cut less than the small players; for the average company, 2020 guided capex is 29% lower than 2019; in total, it’s 22%. See Exhibit 1 showing capex declining with production rising, Exhibit 2 for a rundown of cuts by company, and Exhibit 3 showing a scatter of cuts by size of company with cuts skewed in direction of smaller players
  2. Small players are cutting where they can, but with breakeven economics at least $30/barrel no matter what oil play, they are reluctant to cut existing production. Exhibit 4 shows breakeven by play; Exhibit 5 shows continued oil output still flat at prior year levels (we have cuts in growth, not a decline in production).
  3. Small players may fold. Cash flows are negative. Debt is at all-time highs. Capital markets will be reluctant to issue debt (even at a high yield) to fund distressed oil companies. As they hemorrhage, eventually they may run out of options and option value. Exhibit 6 shows the median debt for high yield companies is up 300% since 2008 and for investment grade companies, it’s up 91%. I’m not bothering to show it vs. cash flow as cash flows are largely negative.
  4. We will likely not run out of storage capacity. According to the Energy Information Associate (EIA) the US has about 653mn barrels total storage capacity, with 372mn barrels already occupying those refineries and tank farms, or 57% of the storage capacity. That leaves about 280mn barrels of remaining capacity. Over the past three weeks, inventories have been rising by about 16mn barrels per week. At that rate, with no supply response, we run out of capacity in 17.5 weeks, a math exercise that has sent off alarm bells. However, we produce about 13mbpd (millions of barrels per day), or 84mn barrels a week. You only need to see a 17.5% reduction in output to stop growing the inventory. Even if it’s just a 5% reduction, that extends the window to 24 weeks; a 10% cut would push this to 40.5 weeks. Exhibit 7 illustrates this.
  5. The point is eventually supply-demand dynamics in oil will rebalance. And that does not mean everything is peachy. It means production fell in response to weak demand, and this is when you will the knock-on effects of reduced oil production on other industries. That’s the point of this post and the original post on caution for market positions. Exhibit 8 is a reminder.
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The hard oil reality and its broad ramifications

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I previously wrote about oil and the consumer as the twin engines of the economy in a recent post “Why I dumped all my holdings…”, noting both are sputtering.

Mayday

Both engines are now in full fail mode, with consumer activity shrinking by the most in history, and oil experiencing its worst-ever decline with some parts of the futures curve in negative territory.

Quick note on negative oil: This is exactly what one should see in the oil market, and it is not surprising. There has been an unprecedented negative demand shock, which has led to output exceeding storage capacity. When that happens, an energy producer has three options: (1) Shutdown; (2) Burn the oil off, dump it in the ground or dispose with it, all of which will incur environmental costs; (3) Pay someone to take responsibility for it. Option 1 has not yet largely occurred because Energy and Production (E&P) companies are facing extreme balance sheet risk, and at this point, they are options on oil; if they shut down, they are just very likely bankrupt, whereas if they wait it out, maybe the price will rise and can stave off bankruptcy. Perverse incentives with shutdown economics only triggered by bankruptcy. We saw this in the coal sector a couple of years ago (perhaps the subject of a future post). Option 2 and Option 3 are related; if you have to pay to dispose of the oil, you might consider offering the oil for negative cost.

Technical note: The Monday decline to negative $37/bbl for West Texas Intermediate (WTI) was somewhat technical in nature, driven by contract expiration (beyond the scope of this post, see here for more details) and will not stay in such deep negative territory (the rest of the futures curve already reflects this).

But the point remains, oil is in dire straits, and we have not seen capitulation in the form of bankruptcies from E&P’s. First, we will see growth capex cut, then second we will likely see bankruptcies. This remains a massive headwind to the market.

Why this is a massive headwind to the market

As I wrote in a previous post, “The market is a feckless child…”, the market is ignoring very real problems in the economy and myopically rising on continued stimulus hopes and prospects for the economy to reopen. There is nothing like the shock factor of imminent bankruptcies to wake the market up.

Most importantly, the sharp decline in oil has massive knock-on ramifications for large portions of the US economy. It is not simply the case that oil is correlated with other sectors; it directly drives large portions of the economy as the US is net long oil and when production and spending slow, derivative sectors, such as industrials, will experience negative demand. And in the present climate where the consumer is absent, they are not experiencing the benefit in the form of lower input prices (usually a partial offset and a strong consumer compensated in 2015).

It’s not just Industrials; there are numerous ripple effects to many sectors. Rather than list them, here’s a look at the number of companies citing oil in their earnings calls over time. The dotted box shows the 2014/2015 period when oil fell from $100/bbl to $40/bbl. Notice the number of companies citing oil (for the most part as a headwind). That’s almost half of stocks in the S&P 500 off of which this study is based. Basically every sector showed an increase in this topic on the calls (exception being energy where it was unchanged as they always talk about oil).

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As another confirmation of oils increasingly important role on the economy, correlations have generally fallen in recent years (which is not unusual in a rising market). But not for oil; oil’s correlation to various sectors has risen.

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Things need to get worse before they get better

We likely need to see massive cutbacks in E&P capital expenditures to reduce supply, but that’s likely not enough. Bankruptices probably will occur, and demand needs to return and consumers need to spend, but that seems very far from happening. Remember, one clue to when this will happen is when school’s reopen, and that does not appear imminent. See the exhibit in “The market is a feckless child…” for a look at school closings nationally.

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So if you haven’t yet evaluated if you can withstand a precipitous and long market drop before recovery and noted the unique challenges this market faces, now may be a good time. Here are some thoughts on that.

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The market is a feckless child and school is out

I’m introducing the short blurb with this blog post.

Many people are under the impression that the rapid recovery in the market is an indication that things are fine and will be fine, and they missed an opportunity to buy a dip. Here’s a sample of someone presenting that view.

I’d disagree with this for three main reasons:

(1) Anyone looking to the market for confirmation is doing it backwards. In my early days as an investor, I thought the market was the ultimate barometer of truth and viewed it as “right” no matter what; I thought that if one were on the wrong side of a stock (or market broadly), one needs to take a lesson from the market and understand where they are wrong. Experience has taught me this is just dead wrong. The market (and stocks) are prone to tantrums and irrational thought. Be a parent, have some conviction that you know what is right and don’t take your lessons from a child.

(2) We have seen an unprecedented recovery in the financial markets in the past three weeks, far faster than normal. For reference, it took 231 trading days for the market to recover 25% off the trough levels in the 2008-2009 crisis. In 2020, it’s taken 23 days. It took 327 days to recover 50% in 2008-2009. In 2020, it’s taken 38 days. That’s just very fast, arguably too soon, with an economy that is set to see a 40% decline in GDP. Just look around you – everything is shuttered, and as I noted in my post, “Why I dumped all my holdings…”, the consumer is 70% of the economy and most of its growth; that engine is clearly in full fail mode, it is not going to turn around anytime soon (regardless of a turn in the second derivative of Covid-19 death rates), and all datapoints from here on out may deteriorate (or show transitory improvement then deteriorate) (just look at today’s retail sales, industrial production, etc.).

(3) The massive recovery in a short window, when we may not have even seen the true trough, reminds me of a feckless child erroneously applying faulty logic, often from prior examples. But the present situation is not similar to the past; it is its own animal. If you’re taking your cue from the market that the economy will just turn back on immediately, first note that the VIX (volatility index) is at 40%; we’re bound to see wild (silly) swings in the market. Second and most importantly, look at school closings as a barometer. The vast majority will not open until September. Think about how much revolves around that. I don’t believe you see the switches turn back on until school is open.

S&P 500. Underlying data from Bloomberg.
Source: https://www.edweek.org/ew/section/multimedia/map-coronavirus-and-school-closures.html
VIX index is above Financial Crisis levels; you should see moody swings.