Last week the market was having spasms and tantrums all over, up and down in big ways after the Fed announced a 50-basis point hike on Wednesday. The market is under extreme stress, something is going to step in to stop this level of volatility. It is just not normal for the market to be up or down 3-5% this frequently.
A new CPI will be released next Wednesday. If inflation is showing signs of peaking and or slow down, then the market could have a relief rally, perhaps it will last a little longer than one day!
Whether we are going to have a relief rally or not, we are dealing with a bear market because the Fed is hell-bent on fighting inflation.
It looks like the end goal of this correction is to reach the 200-week moving average, which is 3468 for S&P 500 index right now. In 2018 correction, the S&P 500 touched its 200-week moving average and then bounced immediately. 200-week moving average is a 4-year average, roughly. So that’s a sizable correction. If indeed the S&P 500 reaches its current 200-week moving average, S&P 500 index will correct 27%! We do see it might take to October to reach the price target, so there will be vicious rallies along the way.
The financial conditions index is very tight right now, comparable to the financial conditions during the 2008 financial crisis. Financial conditions index takes into consideration of the strength of the Dollar, credit spreads and stock market price, etc.. During tight financial conditions, the Fed normally is easing not tightening. So this time is different. The financial conditions are tight and the Fed is hell-bent on tightening. What’s also different this time is the strong balance sheet, both in consumers and corporations. The vast stimulus money went into consumers and corporations directly and they haven’t been wasted yet, although quite a bit of money was burned in the hyper growth stocks.
Besides the Cathie Wood led bubble in bitcoin and hyper growth stocks, there isn’t a structural issue similar to the mortgage credit swaps engineered by Wall Street firms during the 2007-2008 financial crises. Yes, we have some exogenous shocks from the War in Ukraine, but it is mostly in the commodity area that led the Fed to raise rates.
We believe this correction is event driven, driven by Covid and the War in Ukraine. An event driven correction normally takes about 9 months to reach 29%.
The energy sector XLE ETF is showing no signs of slow down. If indeed the economy is heading into or already is in a recession, then the 10-year treasury yield should peak now and the XLE will also show signs of topping. So far the 10-year yield and XLE are acting as if the economy is in full steam and recession is nowhere to be found. This also gives us a hint that the current correction will not morph into a 50% correction in S&P 500 this year.
We looked at XLE longer term chart and examined the prior oil bull market from 2002 to 2008. Here is what we found:
- XLE bottomed in 07/2002 while the S&P 500 bottomed in 10/2002.
- XLE jumped over its 200-week moving average in 01/2004, turning into a structural bull market. It took 17 months to achieve a structural bull market status.
- Crude oil rose above $40 (all time high) during 2004 prompting the Fed to raise rates in 2004-2006.
- The combination of rising oil and higher short-term rates caused bond yields to spike higher during 2005 to 2006 which helped end the bull market in rate-sensitive housing stocks.
- XLE peaked in 2008 after every other sector has been decimated. The S&P 500 peaked in October 2007.
In today’s oil bull market, we see some similarities:
- XLE bottomed in 3/20/2020 with the general market
- XLE jumped over its 200-week moving average in 01/2022, turning into a structural bull market. It took 21 months to achieve a structural bull market status.
- High inflation caused the Fed to raise interest rates in 03/2022
- The rate-sensitive sectors (housing & hyper growth etc..) have been damaged by rising rates.
In recent XLE history, there were three times that XLE jumped over its 200-week moving average:
- XLE jumped over its 200-week moving average in 01/2004, XLE peaked in 05/2008. The oil bull market lasted about 4 years.
- XLE jumped over its 200-week moving average in 11/2010, XLE peaked in 06/2014. The oil bull market lasted about 4 years.
- XLE jumped over its 200-week moving average in 01/2022. How long will the oil bull market last?
If history is any guild, we can reasonably expect the oil bull market to last about 4 year from the time it jumped over its 200-week moving average.
There are many fundamental reasons to support the oil bull market:
- Oil has been in a 12-year bear market. Under the ESG (environmental, social and governance) pressure, the crude oil has been deemed dirty where capital investment has been restricted.
- The oil industry has learned lessons from prior cycles and now refused to return to drill baby drill business model. The big oil companies now return 50-80% free cash flow to investors via share buybacks and dividends. They only invest for about 5% production increase. The commodity business is a tough one, the more you produce, the less money you will make. You are your own enemy.
- Oil and gas sector goes from 29% of the S&P 500 in 1980 to about 4% today, the lowest in more than 40 years.
- Of course, the War in Ukraine contributes high oil prices in a great deal.
The equities bull market started in 1982 ended in 2000 DOTCOM bust. The 2007 top was a double top against the 2000 top. The 2007 top was finished by high oil price. The housing bubble could have been going forever until the big oil to crush it.
The equities bull market started in 2009 will not end until the high oil price to crush it like what happened in 2007-2008. High oil prices cause structural problems in society. So look through the lens of big oil, the equities bull market will not end until 2025-2026. If indeed the equities bull market goes to 2025-2026, that’s a 17-year run from 2009, a pretty good one.
Below is a XLE weekly chart. It is very overbought, but it can still go higher in the next few weeks. It’s only first week in the current weekly cycle and it has already taken out prior cycle high.
The correction in the general market didn’t do any damage to big oil.