Futures

Is the Stock Market on a Slippery Slope?

dondawson
Don Dawson
Instructor

We have all been watching this Stock market Bull run since the 2009 lows were in place.  And of course that means many pundits have been trying to pick when it will end.  Unfortunately for them and great for us, they have been wrong as usual.  Oh, why is it good for us?  If they are selling into this rally they will be providing liquidity for us trend followers.  But eventually the Stock Market will run out of buyers and then there will be more sell market orders than buy market orders and the market will correct.  When?  Who knows!!  Our charts will tell us when the trend changes and we can then sell into the bear market rallies.

While the Federal Reserve’s Quantitative Easing policy helped to provide liquidity to the markets during this bull market it also provided capital for international and domestic infrastructure to be built.  To have the ability to build this the world needed energy products, namely Crude Oil.

There are two primary oil markets in the world – Brent Crude Oil and West Texas Intermediate Oil (WTI).  Brent is a product of the North Sea and is traded on the Inter-continental Exchange (ICE) and West Texas Intermediate is a product of North America mainly Cushing, Oklahoma and trades on the Chicago Mercantile Group Exchange (CME).

Brent has been the benchmark of the oil markets for many years.  Brent is a better quality of oil and requires less refining than WTI.  Over the last 4 years the Spread has been as wide as $23 premium to Brent.  Today it is back to a more normal parity.  When a market can carry a premium like the Brent did to other oil products you know it is in high demand around the world.

Energy products are in such high demand around the world all year long and this is during normal times.  But imagine when there is extra demand?  What do you think that does to the price structure of energy products? Or what would happen if there was all of a sudden lack of demand?

To measure this demand we can follow the price structure of these products by looking for contango and backwardation in their prices.

Table 1 is an example of the price structure of both WTI and Brent on the day this article was written.

Month

WTI

Brent

Nov

93.54

97.00

Dec

92.62

97.63

Jan

92.02

98.21

Table 1

Contango in a market is best represented by the Brent market currently.  Notice how the front month (Nov) is priced lower than the back months.

Backwardation in a market is best represented by the WTI market currently.  Notice how the front month (Nov) is priced higher than the back months.

Contango markets are also called Normal Markets for good reason.  Normally Commodity Futures contracts reflect Commercial trader activity of storing the Commodity for future delivery, no shortage of the Commodity or immediate need.

Backwardation markets are also called Inverted markets.  This is not so normal in most markets, but Crude Oil is an exception.  When markets are in backwardation there is a feeling of scarcity of that particular Commodity at the current time.  Commercials are not storing this product anymore, they are actually having a hard time getting their hands on it and when they do they are immediately shipping it.

Normally energy markets stay in backwardation due to this extreme demand for oil around the world.  But what happens when the world does not need so much energy?  Does that tell us anything about the global economy when the world is flush with liquidity from Central Banks around the world?

From Table 1 you saw that Brent has gone into contango while WTI was in backwardation.  Brent is the benchmark energy product of the world.  If world economies begin to slow down do you think there is as much “immediate” need for oil?  Perhaps the Brent Oil market is telling us something about world economies.  It appears the Commercials are now storing Brent Oil for future delivery dates.  This certainly does not look like the price structure of a booming global economy.

The current contango started around June of 2014.  The last time Brent Oil went into contango was November of 2013 and in January of 2014 the S&P corrected approximately 6%.

The time before that was February of 2011 and in March of 2011 the S&P corrected 7.5%.  Figure 1 illustrates this example.

Fig 1

Fig 1

While I am not a top and bottom picker of the markets I do respect events like this as a possible warning sign the Stock Market might be on a slippery slope.  This contango does not tell me to sell tomorrow.  It merely means that when the charts begin to show some weakness that I already have a very strong odds enhancer in my favor of getting on board the new trend if and when it starts.

“A year from now you may wish you had started today.” Karen Lamb

–      Don Dawson

Disclaimer
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