Fasanara Capital: risk of a heavy sell-off in the months ahead

Upcoming catalysts for risk-off: US earnings, OPEC meeting

As anticipated in previous updates, we remain wary of more equity weakness to come, and stay put. In global equities, limited upside is combined with the risk of a heavy sell-off in the months ahead. We keep dry powder ready should the market become way cheaper between now and September, as we expect.

Within this background, two catalysts are particularly relevant over the next few days:

 

  1. US Earnings next week

 

We believe that acknowledgment of falling earnings will meet expensive valuations next week. Negative EPS guidance runs at a 10year record, while P/E Shiller adjusted at 25.80 stands at an historical highs, most often associated in the past with heavy corrections (see chart below). High leverage (NYSE leverage chart below), absence of buyback tailwind (blackout period) and illiquidity may add emphasis to any gap down. JPMorgan will release numbers tomorrow. Other key releases will follow next week. Let’s see.

 

  1. OPEC / non OPEC meeting in Doha on Sunday

 

As we speak Brent Crude trades at 44.40. We are bearish on Oil going into the Doha meeting, believing that there is a fair chance of a disappointing outcome/fallout post-meeting. While it is difficult to assess consensus expectations around the event, we believe the market may be associating too much of a weight to a freeze in production (i), which may not even be agreed upon (ii).

(i) The market was similarly disappointed last year, when putting too much weight on the relevancy of a decreasing US oil rig count, believing it would have led to diminishing supply. In contrast, new technologies led to improvements in productivity, and generated the unexpected outcome of increased production and inventories in the face of decreasing rig count (we believe additional improvements in oil rigs productivity are likely this year and next, similarly to what happened to gas rig productivity in the past years). A freeze in production may also similarly fail to rebalance the market, contrary to what the market seems to wishfully assume at present.

 

(ii) Agreeing to a freeze in production at current levels is both an inconsistent strategy and an immaterial achievement:

  1. It is immaterial achievement as it freezes production around record supply levels, let alone whatever excess production is carved out from limits (Iran’s waiver, production coming from refineries and petrochemicals, US frackers, Canadian sand, etc). Charts below.
  2. It is inconsistent with the market share price war fought by Saudis to preserve market share for 18 long months against incumbent US frackers / Russia / Iran. Pushing prices down 60%/70%  will have achieved little if now that such players are under stress they are given a breathing space and are let to live another day. 83% of US frackers are believed to break-even at approx. 38$, with such break-even moving lower on advancing technology (horizontal drilling as opposed to vertical, flexibility of the rigs, shortening rigs’ time to delivery). At current prices, such producers are incentivised to expand production, not contract it, to cover fixed costs. Rising inventories are there to testify it. Also, 2020 oil forwards at 54$ have allowed producers to hedge production at very decent levels, an unlikely window of opportunity only a couple months ago. Flooring prices at or above 40$ is inconsequential to the strategy followed by Saudis in the past 18 months.

 

The risk to this view is twofold: 1) earnings beating consensus, 2) Doha agreeing to a cut in production. As we believe both to be unlikely, we think the risk-reward of being bearish risk assets going into next week is appealing.

 

Other risk-off precursors concord in spelling trouble ahead for markets from here. In our CHARTBOOK last week (please reach out if you want a copy) we briefly analysed: volatility term structure (3-months vol on 1-month vol) – oil volatility (oil vol on equity vol) – Nikkei over S&P –  JPY dropping below 110 –  Gold – EU banking sector. They may well all be wrong at the same time, but unlikely. A catalyst seems to be needed for risk assets not to sell off, as opposed to the other way round.

 

Shiller PE ratio

P/E Shiller adjusted at 25.80 is at historical highs, most often associated in the past with heavy corrections

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NYSE Margin Debt

Margin Debt on the New York Stock Exchange is around historical highs.

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Brent (CO1) is currently breaking through its 200d moving average

The 200days moving average has proved a very strong resistance since 2014.

Brent rallied 60%+ in less than three months from Jan ’16 lows and it may prove difficult to break above from current levels.

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Brent forward 2020 vs spot

Brent 2020 contract helped producers hedge future production without going offline

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IRAN Crude Oil Production Output (1000 Barrels / Day, 2011 – Today)

Since the lifting of the ban, Iran is continuously increasing its daily production

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TOTAL OPEC Crude Oil Production Output (1000 Barrels / Day, 1966 – Today)

Crude Oil Output from OPEC countries is at its highest historical level

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US Crude Oil Production Output (1000 Barrels / Day, 1920 – Today)

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RUSSIA Crude Oil Production Output (1000 Barrels / Day, 1920 – Today)

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Crude Oil Total Inventories  (1000 Barrels, 1982 – Today)

Oil inventories are still close to the highest historical level, despite the latest inventories drawdown in March ‘16

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Total Inventories vs. Brent Price

In latest years, rebounds in the oil price have anticipated (small) drawdown in inventories, and not vice versa.

We do not think that the latest decrease in inventories is a bullish signal for oil, but just a natural consequence of the recent oil price increase.

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