Doom, Gloom, And Negative Oil Prices

Oil Price

For anyone who is following the financial markets these days, Monday was an eye-opener.

For the first time in history, the price of oil has gone into negative territory. At its nadir, a barrel of WTI (West Texas Intermediate, the US benchmark for oil) traded for minus $40.

That’s right. If you owned a barrel of oil, you had to pay someone $40 to take it off your hands.

Negative Oil Prices

There are two primary reasons for it. One is that the supply of oil far outweighs demand at the moment, with the word economy grinding to a halt in the lockdown.

As a result, storage facilities around the world are full. There is simply nowhere to store all the new oil that continues being produced.

The other reason is the fact that most oil trading is done via futures. Without getting into too much detail, what you need to know is as follows.

As the futures settlement date approaches, futures traders sell their rights to the underlying asset (in this case, barrels of oil) to those who ultimately consume it.

Alas, consumption has dried up and the oil traders quickly found themselves up against the wall.  Going to some god-forbidden place in the middle of Oklahoma to take physical delivery of millions of barrels of oil was clearly not on the agenda.*

The shocks quickly reverberated through the system. Have the markets gotten too far ahead of themselves with the recent rally?

Good Times, Too Fast?

The recent rally has certainly raised some eyebrows. As of Monday, more than a month into an unprecedented global lockdown, the S&P 500 was back up to levels seen in June 2019. The divergence between Main St and Wall St could not have been more astounding.

Of course, the S&P 500 is hardly an appropriate barometer for the global economy. In particular, the tech majors now represent c.20% of the index. They’ve held up particularly well in this environment.

However, even the tech sector is beginning to raise some questions. While Amazon, Alphabet, Microsoft, and Netflix are holding their ground in the current environment, they are bound to suffer if there’s a prolonged global downturn.

What good is having the biggest public cloud or the leading CRM software suite if millions of businesses go bankrupt and can’t use your service?

Even if we do build on our success in flattening the curve, we are far from being out of the woods. China is still figuring out a way to fully reopen its economy. The US still doesn’t have a clear path forward.  And here in Europe, the mood music is certainly one of apprehension.

While for many businesses outside the hospitality and travel sector trading has held up reasonably well, management teams are certainly looking for ways to tighten their belts.

The more foresightful (and well-capitalized) companies are focused on reinforcing their businesses so that they can get off to a running start out of the gate. This means investing in their people and staying in front of their clients, even though near-term business prospects are limited.

The ones caught flat-footed by the crisis are shoring up liquidity and furloughing people. Not exactly a leading indicator for a robust economic recovery.

So how come the markets are so exuberant – and what does it mean for you?

The “Fed Put”

In financial circles, there’s a term called the “Fed Put”. In simple terms, it’s a belief that no matter how bad things get, central banks and governments can always rescue the economy through a combination of monetary and fiscal measures.

This exactly what has been playing out in the markets over the past two months.

The Fed has essentially nationalized the yield curve by expanding its bond purchases to include high-yield securities. This drives down bond yields and encourages investors to buy equities. Now, if only the Fed could figure out a way to buy oil…

In the meantime, governments have signaled readiness to do whatever it takes to cushion the economic impact. Yes, capitalism without bankruptcy is like Catholicism without hell.  And yet, after bailing out the banks ten years ago, letting Main Street go bust now would be pure political suicide.

I can’t blame them. When your house (and political future) is on fire, you do whatever it takes to put it out – and think about cleaning up later.

The Day After Tomorrow

You may well be forgiven for thinking its all a house of cards bound for the inevitable collapse. But if there’s one thing I learned over my investing career it is that betting against the stock market (and by extension, the governments) is a losing strategy.

If you want to build wealth, you simply have to play the game whether you like the rules or not. Otherwise, you need to make a conscious decision to stay out of the markets (and that includes property) for the rest of your life.

As Lenin famously put it, “One cannot live in society and be free from society”. It just doesn’t work.

There’s nothing worse than being on the sidelines for years, only to finally jump in when you’ve missed most of the upside. Kind of like the people who are still upset we’ve abandoned the gold standard.

If you were to listen to their arguments back in 1971, this is the rally you would have missed. Do you really think the S&P is going back to 95?

S&P 500 Performance Since 1971

Yes, dealing with the aftershocks won’t be easy. But we’ve done it before – on multiple occasions.  1987, 2001, 2008 – I have faith in our ability to overcome this one as well and find a prosperous path forward yet again.

Buying The Dip

Another argument I hear quite often these days is the one of staying on the sidelines for just a little bit longer – and buying the dip at some point over the next few months.

I don’t find it entirely without merit. The situation is still evolving, and we are bound to see more volatility as we go through the next quarterly reporting season.

But if you do choose to follow this path, you better be confident in your ability to pull the trigger. Ask yourself – did you buy back in March? Are you sure you won’t miss the opportunity again?

The numbers don’t lie – mathematically speaking, lump-sum investment trumps trickling your money into the market over time. Read this excellent post by Nick Maggiulli to find out why.

However, for most people (myself included) it’s simply a bridge too far – and there’s less of an argument for doing a lump sum investment when the markets are falling.

Which is exactly why I am continuing with my dollar-cost averaging strategy. Sometimes, you simply need to buckle up and stay in the game. The markets (and the governments) will do the rest for you.

*Interestingly, though not entirely surprisingly, it was the retail traders that got the short end of the stick. Large hedge funds and institutional traders capitalized on the volatility, not least because the big trading houses actually own storage facilities in Cushing, Oklahoma. Not only they knew that storage is filling up quickly but they could also take physical possession if they had to.

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8 Comments

  1. This was very informative and interesting. I do hear people saying ‘I sold my funds and will get back in at the bottom’, but will they really be brave enough to do so? Some might be, but most probably won’t.

    • Most people won’t – and with the markets at 2,800 as of last night, many of them would have done better if they simply held on.

  2. It’s one reason why I think saving for your pension on a monthly basis is such a good idea- its averaging out the market without even trying too. You can capture the lows as well as being invested during the highs as well. Least that’s the idea anyway.

    • Yes – and you get to double or even triple your money on the spot.

      That being said, many people don’t take full advantage of the option – or don’t bother to check how their money is being invested and what the associated fees are.

      And that’s before you get into other key pillars of building wealth such as ISAs and property.

  3. Excellent post, as always.

    Only luck will catch the bottom, but I think the scale of monetary and fiscal stimulus makes the overall direction over the next few months even harder to call. My feeling – and it’s just that – is that there will be a more protracted economic impact over the medium term, but how that reflects in prices with the scale of QE we are seeing to counter it remains to be seen.

    Ignoring the market noise in between, I suspect you’re right: governments will do what is necessary to prop things up and a dollar-cost averaging strategy will yield fruit.

    Thanks for the insights!

    • Thank you. Your thinking is definitely in line with the broad smart money sentiment at the moment, which is “the market is certainly not pricing in the full economic impact of the lockdown, but hey, let’s not bet against the governments!”. And with Trump gearing up for re-election, he’ll certainly do whatever it takes to prop up the world’s biggest economy.

      I suppose the other aspect here is the diminished threat of inflation. In the past, that used to be the Damocles’ sword hanging over central banks. Now, seeing how hard it was to rouse it over the past decade, they certainly feel emboldened to push forward with QE on an even grander scale.

        • Hah, sometimes! To be fair, most of the buyside (asset management) folks I deal with are genuinely smart and hard working. The problem is that there are simply too many of them trying to generate alpha and therefore very few succeed.

          Mostly by luck, though I’m sure there’s a (very small) proportion of people who do it by skill, especially in the less liquid markets (i.e. not public equities)

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