Crash in Oil Market Could Accelerate Decline in Overbought Stocks

02/12/2018 3:13 pm EST

Focus: MARKETS

Don Kaufman

Co-Founder, TheoTrade

The economy and corporate earnings look good. With such good fundamentals, you’d expect this decline no larger than 15%. There could be a 1987-type crash because of the exuberance retail investors since the November election, writes Don Kaufman, co-founder of TheoTrade.

There is no question you should be more bullish on stocks after this sell-off than before it. The stock market’s expected returns improved, albeit marginally when you look at the long-term expected returns. The obvious question is what the expected returns improved from.

Stocks were expected to have very low returns in the long-term, so a correction from those expensive valuations likely means expected returns haven’t even gotten back to normal. My opinion on the short run for stocks has changed because of this correction, but long-term returns will still be poor.

The table below shows a lot of information on the historical changes to the market.

Let’s look at the valuation changes in the recent two years which I underlined. The real compound annual growth rate in the past two years for P/E is 17.6%. The growth in enterprise value to EBIT has been even more significant as it’s up 23.7%.

Corporate debt is also up as the net debt to EBITDA is up 27.3%. Future earnings multiples look good because of the tax cut, but when the cycle ends in a couple years, future multiples will look worse than trailing multiples. Looking worse than extremely expensive is a problem. The Shiller PE Ratio is still above 30, so stocks are very expensive based on the past 10 years of real earnings.

chart 1

Momentum was absurd in January

Getting back to the short-term, stocks got so overheated I had become negative on short-term returns even though we’re at the end of the business cycle where some of the best gains usually occur.

At a certain point of euphoria, it doesn’t matter what the fundamentals of corporate earnings and the economy are, stocks need to fall to clear the speculation. The euphoria had gotten so ridiculous, Bank of America (BAC) raised its full year price target in January and Jeremy Grantham called for a market melt up based on nothing.

When value investors expect stocks to go up based on sheer speculation, it's time to get worried. It turns out that value investors aren’t great momentum traders as stocks have fallen since that recommendation. We were in a bizarre situation where prognosticators were calling for a melt up after we already had one. Stocks levitated without a correction since the November 2016 election.

The table below shows the recent euphoria in stocks which was present before the sell-off. As you can see, indicators like the investors intelligence and the cash allocation were all at least in the 96th percentile.

The market needed to clear out all of the overextended longs. The short volatility trade was only one of the trades that was overextended. That blow up caused investors to panic on Monday (Feb. 5). The other extended trades are simply being long momentum stocks and equities in general. The U.S. is one of the most expensive markets in the world. The long stocks and momentum trade are much larger than the short volatility trade which makes it more dangerous.

chart 2

Oil sell-off can be a future catalyst for a crash

As I mentioned, the sell off in stocks is being driven by trades which went in one direction for too long. Another great example of this is the oil market. As you can see from the chart below, the net position in WTI futures was near the highest ever at the end of January.

The long to short ratio was 11 times for Brent oil and 14.5 times for WTI oil. The oil market has already started to sell off in the past few days. On Thursday, oil fell 1% to $61.15. This was the fifth straight decline which is the longest streak for WTI since April 2017. Brent futures are down 8% from their peak in late January which was a 3-year high.

chart 3

On Wednesday the U.S. Energy Information Administration came out with its latest statistics. It said U.S. crude production hit a record of 10.25 million barrels per day. If it continues to produce oil at this rate, America will outpace Saudi Arabia which is the biggest producer in OPEC.

Crude inventories increased 1.9 million barrels to 420.25 million barrels in the week to February 2. The EIA increased the average 2018 output per week to 10.59 million barrels per day which is up 320,000 barrels.

There could be a triple whammy selling effect in the next few months as the speculation reverses, American production accelerates, and OPEC ends its production cuts. The fundamentals are strong as Chinese consumption increased to 9.57 million barrels per day, but if production exceeds demand, prices will fall.

Jobless claims fall again

We know stocks were expensive and overheated heading into this recent correction.

The question investors are trying to figure out is if stocks will fall into a bear market or finish this decline with only a few more down days. For that answer, we turn to the economic data.

Either the market is predicting an economic decline or this is nothing. The current data doesn’t support the notion that weakness will occur this year. The jobless claims for last week fell 9,000 to 221,000. This is the 153rd straight week they’ve been below 300,000.

If the claims were rising as stocks fell, it would indicate that this correction had legs. The only bearish possibility if there’s no economic weakness would be a 1987-type scenario where stocks fall because they were overbought. That’s essentially a bigger version of the winter 2016 decline. It’s amazing how there was universal agreement that a 1987-type crash could never happen again right before this correction started.

Conclusion  

Stocks are cheaper than they were a couple weeks ago, but they started this decline at extremely overbought and expensive levels. A crash in the oil market could accelerate this decline in the coming weeks.

On the bright side, the economy and corporate earnings look good. With such good fundamentals, you would expect this decline to not get larger than 15%. However, there could be a 1987-type crash because of the exuberance retail investors have exhibited since the presidential election. 

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