The Morning After
The herd mentality took over in the last hour of trading yesterday, prompting the worst one-day loss in three years.
With about one hour left in the trading session, it was clear there was neither rhyme nor reason in the collapse. The market had exhibited some weakness, but not enough to justify this carnage.
This was emotional – and it wiped out months of assets value in the process.
But not to worry. Wide areas of the energy sector are now at levels so far below fair value that there are ample opportunities to recover.
We just need to determine where the floor will develop.
To say investor confidence has been “shaken” is putting the matter mildly. Yet absent another bout with what economists George Akerlof and Robert Shiller have famously called “animal spirits” – the human psychological component to market behavior – that floor will come shortly.
There are several major reasons for this.
- First, the sell-off was an overreaction to some tepid, but hardly chronic, data.
- Second, a one-day early (and anemic) preliminary reading of today's monthly employment figures soured the mood.
- Third, the recurring fear of European debt contagion added another ingredient of uncertainty.
But none of these is new. And that is the overarching point as we move into trading on the proverbial “morning after.”
There were no fundamental reasons for a 60-point drop in the S&P, or for the way it just cut through a major support level (at about 1,220) to almost freefall in the last hour of trading – losing all of its 2011 gains in the process.
There is, however, a fourth reason why the drop was so steep and accelerating. And it is very revealing.
Money Is Moving Out of the Market – Fast
This movement began during the debt-ceiling circus and merely intensified yesterday.
Some of this was the recognition that, in the wake of the debt accord, government spending is now suspect. From defense spending to construction projects, wide areas of the economy that normally benefit from public sector contracts are coming under pressure.
Odd… the budget-cutters never considered the employment, investment, and consignment costs of taking a meat axe to the budget.
The market, on the other hand, did.
Government remains an essential purchaser. So a move to balance the budget only from spending cuts sends a very negative message to stocks.
Yes, heavy debt is a depressing influence on an economy. But so is the interruption in the usual flow of government expenditures.
That certainly has not happened yet, but the market is seeing it on the horizon, and that is another cause of trader angst.
Yet a major consideration now clearly visible involves the money off the table.
For months, commentators have lamented about the huge funds withheld from access by banks. We are now experiencing a similar withdrawal by investors. Investment funds are moving out of equities and into cash.
How bad is it?
The Bank of New York announced yesterday that they would begin charging a fee for large deposits of cash. This is a device that has been used in China, Switzerland, and smaller economies elsewhere, but never in the U.S.
(Perhaps an opportunity will emerge for the sale of very large mattresses…?)
As a store of asset value, commodities like oil a
nd gold have usually benefitted from such environments. Yesterday, however, oil led the decline, while gold also fell.
There are once again prospects that regulators will increase margin requirements in response. That may lower the price of oil and gold even more, although only temporarily.
Here's what you need to remember…
We Are Not in An Energy Recession
The energy side of this equation is largely driven by expected demand. Not actual demand, mind you, but the levels the market anticipates.
In fact, oil is the only commodity that essentially determines that side of the balance by calculating a demand curve, and not by calculating the genuine end-user demand in the market.
Consider also this.
It is well known that increasing levels of energy demand regularly precede major upward corrections in markets as a whole.
That does not happen merely because people wake up one morning feeling more confident about their consumption rates or their lifestyles. It happens because energy usage is a front-end support requirement for a rise in leading indicators, with the recovery taking place in energy well before it registers elsewhere. An absolute majority of the 10 elements in the Index of Leading Indicators are energy-dependent.
In other words, energy in general, and its dominant constituent – oil – in particular, will experience an increase in demand at an early stage of a recovery process, before that recovery is recognized in wider economic sectors.
And the market perception of that forward demand will precede the rise itself. Put simply, the early-stage pop will come in equipment sales, oil field services, and technical support. A broad-based improvement among producers will quickly follow.
There is a secret to how one estimates this development, quite apart from what the pundits and talking heads tell you…
Watch the PowerShares Dynamic Oil & Gas Services Portfolio ETF (NYSEArca:PXJ). This exchange-traded fund will move north as an early indication of the broader move coming.
However, we will not need to wait for a broad-based sector-wide recovery. That is because we are not in an energy recession. Not even close.
Do not fixate on North American and Western European demand projections. These developed regions of the world have not controlled the pricing for some time. Overall global demand remains strong, and that will lead to a return of energy pricing increases shortly.
Remember, however, that the better strategy is always to select individual companies, not to try to play the crude oil price itself. And that will require a move into both stock trades and options.
[Editor's Note: Next week, Kent will be adapting the Portfolios of his Energy Advantage to make sure subscribers are positioned for the windfall coming. If you don't yet get it, click here.]
We can get along with making profits from all of this… if only one thing will happen.
The trading lemmings need to stop running off the side of the cliff.