On Thursday afternoon crude oil futures hit $60 a barrel, and investors hit the panic button. Apparently $59 was fine. $60, for some reason, was a big problem.
There’s nothing fundamental about $60 a barrel. There’s no reason to think that the economy will do just fine with $59 oil, but will fall into a recession at $60. A one-dollar difference can’t be that important. But we know there’s a tipping point out there somewhere, where the oil price becomes too much for the economy to bear. Why not $60? It’s a nice round number. A round, scary number.
So does this mean the end of more than two months of rallying stock prices? Maybe it does — and oil is only one of the reasons why.
Perhaps the best reason to be cautious here is that the rally that began following the bottom on April 20 is getting a little long in the tooth. It’s been a stealthy and somewhat anemic rally — creeping up a little bit, one day at a time, on very low volume. But it really has come a long way. Before the wheels came off on Thursday, the broad-based Russell 1000 Index of large-cap stocks had moved up to within a couple of basis points of making new highs — at levels not seen for four years.
But at this point, the rally is running out of steam technically — oil or no oil. My technician friend Fredric Goodman, who writes an outstanding daily technical report on my web site, put out a major intermediate-term buy signal about a week before the rally started. Believing that the market is in a long-term uptrend, too, he told readers to go whole hog and use margin to double-up in leveraged positions in stocks. It was a great call — but now Fred is moments away from reversing course.
The sell signal that will reverse Fred’s April buy signal will probably come today — Friday — unless a pretty impressive rally comes out of nowhere and forestalls it for a few more days. Fred works his technical magic, by the way, by examining dozens upon dozens of indicators every day. The best ones are combined into a single “super-indicator” that he calls the Summary Index. Fred’s intermediate-term buys and sells happen when the Summary Index rises or falls through certain key levels that Fred has identified as trigger points over the years.
At the same time Fred uses a long-term technical tool called the Trend Indicator. Fred had the confidence to take double positions in stocks at the April bottom because the Trend Indicator was in a long-term “uptrend state.” That same state still exists today, and it serves to mitigate Fred’s bearishness about stocks, even though a Summary Index sell signal is coming right up. So Fred will sell long positions — but he won’t open up outright short positions. For now, he expects a decline following the sell signal to be a mild one.
I agree, but for totally different reasons. Major declines simply do not set in when stocks are as undervalued relative to bonds as they are today. As I’ve written here many times over the last several months, that undervaluation is near historic extremes associated with major bottoms, not tops. Stocks may indeed drift lower — but I really do see the downside risk as quite insignificant in the grand scheme of things. If you want to try to catch an intermediate term top and avoid even small losses that may ensure — like Fred is planning to do — then selling some stock here makes good sense. But be prepared to take advantage of any decline to buy stocks back even cheaper than they already are. But don’t be too greedy — they won’t stay that cheap for long.
One of the reasons for that, other than valuation, is that I don’t think these record oil prices are going to last for very long. The reason why is that there is no fundamental reason why prices are so high to begin with. What I mean by that is that there is no reason that has anything directly to do with the oil markets — although there are plenty of external reasons.
There’s no oil shortage. The world pumps more barrels each day than it consumes. The excess is going into unprecedented levels of storage. You don’t make money by storing oil — you make it by selling oil. Sure, when prices are rising you realize inventory gains on your storage, but that’s not the oil business — that’s just speculation. And it never lasts. Speculating on oil right now is like speculating on dot-com IPOs in March 2000 — there’s no fundamental reason why it should work, but it’s nevertheless working (right up until the moment when it suddenly and very violently stops working).
And don’t believe all that silliness about high crude prices being the result of scarce refining capacity. Use your head! If refining capacity is scarce, then that means that we can’t even use the oil we’ve already got. Why would anybody bid up prices for more oil that we can’t even refine?
Here’s the real scoop on oil: It’s all about inflation. Note that the oil price has soared over the last month in perfect tandem with gold — another excellent inflation indicator. Inflation pushes up the price of all commodities — and when that inflation is the result of the Fed keeping interest rates too low, it means it doesn’t cost very much for speculators to borrow money to support their oil inventories. A double whammy on oil prices.
The last peak in oil prices was last March. What slapped prices down to more reasonable levels then was the Fed announcing that they were getting increasingly hawkish on inflation. But since then the market has come to doubt that the Fed really means it. The 10-year Treasury yield has fallen as much as 80 basis points since then, suggesting that the market thinks the Fed will soon stop hiking interest rates.
It’s really getting silly. PIMCO’s bond guru Bill Gross even thinks that the Fed could start cutting interest rates soon. But remember — he may be a guru, but he’s not always right. At the very bottom of the stock market in late 2002 he was the one predicting “Dow 5000.” I think he’s going to be just as wrong this time.
That’s because when a mere guru takes on The Maestro — Alan Greenspan — I’ll be betting against the guru every time. There’s an FOMC meeting coming up next Thursday, June 30. Greenspan knows full well that a soaring oil price represents a major inflationary risk (and in his heart of hearts, he probably also knows that it represents the consequence of his own inflationary policies). He got more hawkish in March when oil made highs a couple dollars lower than today’s price. And I think he’s going to get even more hawkish now.
Does that mean I think he’s going to raise interest rates by 50 basis points, rather then the 25 the market expects? No — it’s 25 for sure. But I’ll bet the carefully coded language of the FOMC’s statement after the meeting will be adjusted to let the market know that there’s going to be no vacation from rate hikes for the rest of the year.
If that happens, bond prices are going to crater and stay cratered. That could spook stocks for a while — but don’t forget that at the same time the oil price should fall dramatically, too. Oil traders will realize that the Fed really does intend to fight inflation here, and the financing costs of those record oil inventories will become increasingly painful to speculators as rates rise. Yes, stocks will be annoyed by higher rates. But lower oil prices — and the prospect of less inflation risk — will more than compensate.
It’s a risky moment, for sure. But the great news for stock investors is that if we get it wrong, stocks are already priced for a lot of adversity. If we get it right, it will be a magnificent finale to a remarkable career for The Maestro — and undervalued stocks will make a major upside move. One that nobody is expecting right now — which makes it all the more likely.
The above is an “Ahead of the Curve” column published June 24, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.