The Only Chart That Matters: Why Oil is the Market’s Dominant Fundamental Factor

 

In the world of growth equity, we usually spend our time obsessing over earnings revisions, VCP setups, and institutional accumulation. But in the current environment, those secondary factors are being drowned out by a single, dominant fundamental: the price of Crude Oil. If you want to understand the direction of the broad market right now, stop looking at the Nasdaq 100 and start looking at the energy tape.

The Inflation Anchor

The reason is simple: Oil is the primary input for almost every aspect of the global economy. When energy costs spike, it acts as a massive "tax" on both consumers and corporations.

• For the Consumer: It’s less discretionary income for the high-growth services and products we trade.

• For the Fed: Higher oil prices keep the "inflation fire" burning, which forces interest rates to stay higher for longer.

The recent data highlights just how drastic this correlation has become. As highlighted by The Kobeissi Letter, we are seeing a nearly perfect inverse relationship where every meaningful spike in Crude is met with a corresponding liquidation in the equity indices. It has become the "Master Key" that unlocks, or locks, market upside. 

https://x.com/KobeissiLetter/status/2033958793906950647  

Navigating a Macro-Driven Tape

When one single factor like Oil becomes this dominant, the "stock picker’s market" often goes into hibernation.

1. Correlation Goes to One: During these periods, individual stock stories often get ignored. A company can report a "beat and raise" quarter, but if Oil is up 3% that morning, the stock will likely be sold regardless of its fundamentals.

2. Relative Strength is Critical: We are watching for the stocks that can stay "green" or hold their 20-day moving averages even as the "Oil tax" weighs on the rest of the market. These are the true leaders that will fly the moment the energy pressure eases.

3. Patience as a Position: If the energy tape remains parabolic, we respect the macro risk. We don't fight the "Oil Master Key." We stay lighter, keep our stops tight, and wait for the "regime" to shift back toward a focus on individual growth stories.

The Bottom Line

At Worch Capital, we don't ignore the elephant in the room. Right now, Crude Oil is the elephant. Until we see a cooling in energy prices or a decoupling of this tight inverse correlation, we are treating the price of Oil as the ultimate "Green Light/Red Light" indicator for our exposure. We aren't here to be "right" about the macro, we are here to be in sync with the tape.

New highs but signs of divergences

The market indices continue to chug along as they steadily make daily new highs with the exception of small caps which have lagged recently.   We have not touched on correlations of late but this has proven to be the year of stock picking.  During most of the QE environment from the market bottom in 2009 correlations remained abnormally high as asset classes and sectors followed each other in the same direction in a herd mentality fashion.  However sector correlations have completely diverged throughout 2017 and are hitting the lowest levels by a wide margin.  Below we look at the 30-day average correlations of the major S&P 500 sectors.  We overlaid the trend of the S&P 500 during the same time frame.  It clearly illustrates how 2017 has been a stock pickers year as correlations have collapsed.  We believe this is another endorsement for active management going forward.

Below is a great blog post from Chris Kimble that highlights the divergence in equal and market capitalization indexes.   This shows how a few big cap stocks (think FANG stocks) that have performed well are propping up the indices.  The equal weighted indexes are under-performing the cap weighted indexes by a whopping 25%.  We also see this divergence in our own breadth indicators.  One simple one we follow is the amount of stocks trading above the 20 and 50 day moving averages.  The second chart shows how momentum has peaked prior to price displaying a negative divergence.  This usually is resolved to the upside but we can see typically when momentum fades this tends to lead to a level of consolidation or pullback before breadth picks up and momentum resumes. 

The S&P remains overbought and with momentum fading we could be in for some short term weakness as the market digests the recent gains.  However, as earnings season had been favorable to equities and with the potential for tax reform this should keep a bid in the market.  Coupled with correlations at multi-year lows this sets up nicely for an active manager assuming you are positioned in the right areas, as we think the strong will get stronger and the weak performers will be under tax selling till year end. 

The Bulls Have Taken Control: Can They Keep It?

As we noted in our last last post, the post-Trump rally has been accompanied by a huge thrust in breadth.  The signals we noted in that post suggested that the recent action was indicative of some notably bullish outcomes looking out 3-6 months and beyond.  If we considered just the stats, it was a screaming buy signal.

Yet, given the environment and market action of the last two years, many investors have felt a bit gun-shy (perhaps, rightfully so) to step in and buy here.  Not only have they been humbled by a choppy, mean-reverting market since late 2014, they’ve also been forced to consider the ramifications of the likely Fed rate hike that we’ll be seeing in a few days.  Is it fully priced in?  What’s the reaction going into year-end? Are we moving from a QE induced bull market into an earnings driven bull market as analysts like Raymond James' Jeff Saut has been proclaiming for some time now?

"Students of stock market history will recall secular bull markets tend to have three legs. If Mr. Tuey is correct, we are barely into the second leg of this bull market, which as previously stated, he thinks is going to be, “The longest and strongest leg of all.” Of course that “foots” with our thinking that there is at least another seven to eight years left in this secular bull market. In fact, Tom Lee, sagacious captain of FundStrat, recently published a chart showing the potential for this “bull” to extend into the 2029-2034 timeframe. That seems a touch long to us, but heck, if that’s what the markets give us, we will certainly take it! I did find Tuey’s closing comments, in Gary Lamphier’s article, intriguing: “The second key point is that for the past 100 years or more, the more severe the economic downturn, the more powerful and enduring is the subsequent bull market. When you’re faced with financial Armageddon as the U.S. was back in 2008, the Fed eases much more aggressively than ever before, and they stay accommodative for much longer than normal.”

To be sure, all of this fits with our thesis the equity markets are transitioning from an interest rate-driven to an earnings-driven secular bull market. To that point, many of y’all know we are on an email “string” with folks like Arthur Cashin, David Kotok, Dennis Gartman, Bob Pisani, etc. It is a freewheeling exchange of thoughts that provides very interesting insights. Last Thursday, the savvy Bob Pisani wrote this:

President-elect Trump's proposed nominee for U.S. Treasury Secretary, Steven Mnuchin, said on our air yesterday that the administration was still targeting a reduction in the corporate tax rate from 35% to 15%. The current 2017 estimate for the entire S&P 500 is roughly $131 per share. Thompson estimates that every 1 percentage point reduction in the corporate tax rate could "hypothetically" add $1.31 to 2017 earnings. So do the math: if there is a full 20 percentage point reduction in the tax rate (from 35% to 15%), that's $1.31 x 20 = $26.20. That implies an increase in earnings of close to 20%, or $157. What does that mean for stock prices? The S&P is currently trading at a multiple (PE ratio) of 17, high by historical standards. Applying that 17 multiple to earnings of $157, we get a price on the S&P 500 of roughly 2,669 for 2017. That is 469 points or roughly 20% above where it is today.

Our sense is the new administration will not be able to get the corporate tax rate down to 15%, but even at a 25% rate, it implies an additional $13.10 to the S&P 500’s bottom up operating earnings number ($1.31 x 10 = $13.10). Using Bob’s same math produces an earnings estimate of $144.10, and at 17 times earnings, it renders a price objective of roughly 2450 for the S&P 500.

The equity markets have rallied hard on the belief in a pro-growth administration, reduced regulation, lower taxes, increased infrastructure spending, a reset on trade toward the benefit of American companies, and the reflation trade. If this optimistic scenario comes to fruition, the Penn-Wharton Budget Model targets between a 1.1% and 1.7% increase in GDP growth beginning in 2018. If true, GDP growth could ramp to ~3%+, suggesting stocks are not all that expensive. Verily, we have never wavered on the belief that we remain in a secular bull market. Such bull markets typically last for 14-15 years and tend to compound at around 16% per year. If past is prelude, we should have another seven-plus years in this “bull run.” Will there be pullbacks? Of course there will be, but pullbacks should be viewed within the construct of a secular bull market." 

For those that have mustered the courage to aggressively buy this rally, they’ve also been afforded some ripe opportunity to outperform through stock-picking.  We track the daily correlation of the underlying S&P sectors and our data shows the measure falling to its lowest level since August and before that late-2014.  Taken a step further, the data is also borne out by the clear divergence in performance for said sectors.  Being positioned in financials, energy, industrial, and materials has well outperformed laggards like utilities, consumer staples, technology, and health care over the last month.

Also favoring the bulls, was yesterday's major push higher in the number of stocks on the NYSE making new 52-week highs.  The tally was the highest reading since 2013 and according to Nautilus Research it marks a significant technical feat and confirmation that bullish conditions are afoot.  Their findings show that when the S&P 500 makes a new high and is accompanied by a new high in the 52-week individual stock reading (as happened yesterday), the market continues higher.  Going back to 1990, this setup has occurred 16 times and in every instance the S&P has been higher one year later by an average of nearly 15%.

We are aware that this market is now overbought on multiple short-term conditions.  Also in the last few years the above indicator has been a good tell for potential short term tops and bottoms.  So if nothing has changed and we're still in the same environment of the last two years, then we could be closing in on a near-term top.  

However if we are entering a new market environment in which a trend can be sustained ala 2013, we can be confident in sticking with the trend and going in search of bigger profits.  If this is the case, and we are entering an earnings driven market the argument for active management could be coming back into vogue.

Brexit Correlations

With the "Brexit" decision looming over markets last week we got a fresh reminder of just how tightly asset classes are correlated when the market receives an unexpected shock.  This was the case when Britain, to the surprise of most, voted to leave the European Union.  US government bonds, the dollar, Yen and precious metals all soared higher while global stocks, the Euro and oil got hit hard upon the outcome of the vote.

VIX Term Structure:

Since the start of this sideways, choppy market environment in late 2014 when the VIX term structure has gone above 1 that has been a short term buying opportunity.  Will this time be different??

Revisiting Correlations

We follow correlations as another useful tool to track sentiment in the market.  Typically, during down trending markets everything gets sold at once and fast which in turn causes a spike in correlations.  Tracking sector correlations during market stress gives a nice view of the underlying market.  

Below is a chart of sector correlations versus the SPY going back to 2011.  You can see how they rise during periods of S&P pullbacks/drawdowns.  During this most recent pullback in which we are about 4.2% off the highs, correlations have started to rise.  Since the start of 2013 when this V-bottom market of shallow corrections really kicked into gear, the average pullback in the S&P 500 is 4.5%.  Considering we are 4.2% off the highs with rising correlations and a ton of oversold indicators, we give a higher probability to a potential bounce.  So unless we get a bigger flush lower in prices, correlations are likely to stay in this range of .7 to .8 before correcting lower. 

A recent note from the morning briefing by Nicholas Colas, the chief market strategist at Convergex, sums up the current environment:

"Markets don’t melt down because a few sectors or securities move lower; they drop like a stone because everything declines at once – essentially a price correlation of 100%. Bull markets, by contrast, tend to show declining correlations as varying industry and individual stock fundamentals c reate differentiated asset prices. On the plus side, that’s exactly what U.S. industry group equity price

correlations have done since 2011, when average S&P sector correlations to the index as a whole were +95%. 

This month that average is 82%. Now, the bad news: the long run average since the end of Financial Crisis is 84%. Simply put, we haven’t really broken free of the macro “Risk on, risk off” gravitational pull of systematic worries (read “Greek Debt Crisis”) or central bank watching (read “Fed lift off” and/or “ECB QE”). Should capital market volatility continue to increase – the CBOE VIX Index is up from 12.1 to 19.7 in just 10 trading days – correlations will likely increase as well. That will make “Safe” parking lots for capital very hard to find."

He goes on to list a number of keen observations:

"1. Asset price correlations for the 10 industries of the S&P 500 have been declining since late 2011, when they reached +95%.  That’s good news, as it allows active investors to benefit more from stock and sector picking and gives passive investors a smoother and less volatile ride. 

2. The bad news is that average sector correlations are up over the last month, from 77.6% to 82.4%.  We’ve tracked these numbers for years – since the Financial Crisis, when they skyrocketed – and the correlation between the CBOE VIX and sector correlations is 67%, a remarkably high reading.  Simply put, when volatility spikes correlations tighten up very quickly.

3. The second bad news “Foot” to fall is that average sector correlations since 2009 come in at 83.7%, or right on top of this month’s 82.4%. We have not, in other words, made any real progress in pushing sectors as disparate as Health Care and Financials to trade more on fundamentals than larger market-wide trends. 

4. As market volatility picks up – the CBOE VIX Index is up from 12.1 to 19.7 in just 10 trading days – stock correlations are already at the same elevated levels as the market has exhibited for years.  That’s a problem for two reasons.  First, it means it will be as hard to diversify an equity portfolio from incremental volatility as it has been the last +5 years.  Which is to say “Very hard indeed”.  Second, it also signals that equity markets are still in the sway of macro drivers rather than industry and stock fundamentals.  Yes, given the headlines over everything from Greece to Federal Reserve policy, perhaps that is understandable.  Even as it is unwelcomed."

It will be important in coming weeks to observe how correlations react as the market carves its path. Will it be more of the same and we're reaching an inflection point in both correlations and volatility? Or will individual sectors begin to behave a bit more independently when volatility flares up?

An Updated Look at Sector Correlations and More

Identifying short term tops and bottoms is an incredibly difficult task and something that is unlikely to be done with any consistent certainty.  We choose to follow a specific set of indicators in an attempt to gain a sense of when the market might be putting in a top or bottom over various timeframes.  

For instance, in our Tuesday post, we highlighted the McClellan Oscillator, bollinger bands, stochastics and simple trend lines to show that while the market had moved lower rather swiftly, it had yet to start flashing the oversold extremes that we prefer to see.  

Another indicator we wanted to revisit is the rolling 20-day correlations of several key S&P 500 market sectors.  Simply told, the sectors within the index become highly correlated when the market gets really oversold because people just want to get out.  We've posted on the topic before and think it's really useful when trying to zero in on extreme readings.  As of yesterday, the indicator had yet to reach levels that have been typical of recent short term bottoms.  If you look at the data going back to 2013 in which the "buy the dip" strategy has ruled, we want to see correlations quite a bit higher than where they currently stand before declaring a market bottom.  As with any other indicator, there's absolutely zero chance this measure is infallible on its own but we like to see scenarios where it backs up/compliments the other gauges we follow.  While we're seeing a strong bounce in the market today, we'll be keeping an eye on sector correlations to see how they respond.





Another area we are focused on just like every other talking head is the dollar.  The chart below shows the rapid advance in the last 6 moths.  The USD is currently trading near its upper channel line.  This could act as resistance and bring about some weakness in the near term.  As part of our scenario analysis we've been scanning to see what effect a potentially weakening dollar would have on equity prices.  In fact, if you've yet to start investigating the matter, the Fat Pitch Blog just published his findings and they'd be a great place to start.  His stats show a very mixed bag.  We're going to keep digging.