Tuesday, November 3, 2015

Speculation and Energy Devaluation

The month of November opens with the continuation of earnings season and the introduction of a slew of economic statistics to the respective economic environment. Projections of the markets and where they go from here have now assigned a higher probability to a rate raise, the ominous possibility looms larger as strength becomes more evident. I find the process almost paradoxical. Acting a lot like a contrarian indicator, Fed policy change signals send contradicting signals; for example, markets responded with positive movement when the Fed cited a rate delay despite broad-based economic weakness, Traders have a weird way in deciding what is important and what is not, but sometimes they can be wrong, hences, corrections and bubbles exist. According to MarketWatch, suspicions of another tech bubble (first one in 2001-2002) are looming over data that shows tech spending is moving slower than tech equity cash inflow. Nasdaq growth might prove to be a bit overvalued, especially after impressive earnings surprises from Google, Apple, Amazon, and the like have spurred shopping sprees on their stocks. But ideas of a bubble seem 2009-ish, we just had a correction in August, right? With gains from Monday and Tuesday, the Dow Jones Industrial Average and the S&P 500 have already surpassed the peaks before the August corrections. The DJIA is just 0.2% above that level, and SPX has risen to 1.68% above its pre-correction value. What may be even more frightening is the blitzkrieg of bullish trading that has sent these indexes to these values in just two months. The ETF that measures 100 of the top non-financial equities, QQQ, has been traded even higher over its pre-correction level, about 3.50%. Analysis of these charts shows a clear double bottom pattern off of the August low with support from September and October volume that rivals that of August. It might also be worth noting that, when compared to SPX and DJIA, the price of QQQ shows a smaller drop, a larger retracement, and a deviation that could result from accelerated speculation of exchange traded derivatives. When looking at economic growth figures, this acceleration seems a little premature. Over the past two days, international figures measuring the strength of the manufacturing index showed growth with China's PMI index increasing 1.1 points from last month and the Eurozone's up 0.3 points. Despite the growth, both still lag 1.15 points and 0.27 points from their respective June peaks. In translation, contraction has appeared to stop, but the state of industrials have not fully recovered. The story is further told by U.S. factory order data that came out Tuesday. Falling 0.1% below a consensus estimate of -0.9%, factory orders contracted for the second month in a row with September losses of -1.0% improving from a -2.1% contraction in August. These statistics are optimistic, but altogether not supportive of the 100%-plus retracements of August corrections in major indexes.

One of the major stories of the bullish surge seen by the stock market is the recovery of the energy sector and the stabilization of oil prices. Some might even say that the energy industry is driving the large, long retracement of August losses. After underperforming in late August and the month of September, a reversal in October erased the negative performance and has the sector as one of the major talking points this year. The drivers of price movement in the oil and gas industry have been extensive with reacts to weekly supply and production, the occasional demand outlook report, and even general economic statistics that may warn of more (or less) global weakness. With mixed sentiment, the main problem with energy-related securities is how to determine an appropriate price for an industry ridden with uncertainty. Even earnings reports can be confusing with upstream operations returning losses and downstream doing just the opposite. This is especially the case for integrated service firms that shed no true light on the scope and quality of their businesses. For that reason, energy companies are trading based on sentiment and price changes on the commodities market (WTI and Henry Hub natural gas).

Provided by FactSet
The chart above plots the S&P SPDR Energy Sector Select ETF against the S&P 500 for a comparison of price since 2011. The deviation in mid-2014 as a result of the supply glut sticks out as the main difference in price pattern. Even after that point, the trading patterns have been relatively similar with the exception of a lower energy trading price.On the bottom, quarterly EPS growth has been plotted to show a key valuation number moving with its market price. Before 2015, both securities show a consistent rate of EPS growth as a bullish market, easy monetary policy, and higher energy prices allowed for the expansion of cash flow and earnings growth. By early 2015, energy companies (especially those heavily in fossil fuels) were already starting to devalue with the prospect of lower revenue as their assets were becoming cheaper by the day. Midway through 2015, we see the correction shift both the energy sector and the overall market down in the face of a short-term recession. Quarter three revealed that "recession" to us with S&P EPS contraction of -4.06% for the only time in these five years. The earnings "recession" continued to put pressure on the energy sector with Q3 EPS growth at a new 5-year low of -50.28%, the twelfth fiscal quarter of EPS contraction. Despite the unprecedented EPS contraction, the energy sector has led the retracements in the stock market and build on gains of 14.58% above the 2011 start. As for the possible formation of a bubble, that could be a strong case as fundamental adjustments don't appear to price companies with significant EPS contraction right. It could be that investors are currently trading in a range that they think values these companies well, but questions regarding the future prices maintain a status of unanswerable. Oil and gas companies are expected to default, but which ones and when? Crude oil futures amble along as a security even more difficult to price as they continue to jump around a range below $50. As the global growth scenarios start to become more lucid, energy consumption should paint a more clear picture of what kind of outlook investors can expect. Typically, uncertainty coupled with volatility leads to bad performance (as seen by August), but uncertainty coupled with growth can lead to bubble-like patterns. Investors should watch volume levels to keep track of when a significant reversal might have occurred. Also, watch for similar sectors and other commodities to compare deviations from indexes that tend to move with energy like industrials and consumer goods.

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