Oil and equities — looking for convergence indicators

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Updated: 11 February 2020

 

  • If oil prices have followed the cues provided by the coronavirus outbreak, then the rate of recovery in equity markets has left some surprised.
  • Despite both asset groups thriving in the same environment, divergence between them is not unusual.
  • Data also points to a convergence trade to follow at some point.
  • With potential double-digit gains on the table, there is money to be made from looking for the indicators that point to the end of the trend.

 

The outbreak of Novel Coronavirus has been a catalyst for a dramatic divergence in asset markets. Over the last month, the price of oil (NYMEX:CL1!) has fallen 14.82% and the S&P500 global equity index has rebounded from a mid-month stumble to now be posting positive returns of 1.91%. Taking the drop from its year-to-date high on 8th January, the Cl1! Oil futures index has lost almost a quarter of its value. The 23.55% price drop has taken current price levels to $50.06 at the start of the week’s European trading and further weakness had driven prices below $50 by the time the US markets opened.

Light Crude — NYMEX:CL1! — one-month price chart:

Source: TradingView

The one-day technicals at industry site TradingView show the dashboard monitors for (daily) data pointing to sell. If the $50 price support wasn’t so significant, then the market could be experiencing prices at much lower levels. Should the $50 level be breached, that still might happen. The classic support level S1 is some way down from current prices at $46.47.

TradingView — Technical Dashboard — Cl1!:

Source: TradingView

TradingView support/resistance dashboard:

Source: TradingView

The price action in oil has followed a path that many would predict following the outbreak of a contagious virus, which could be significantly damaging to global trade and commerce. The viral outbreak, which started in China, has caused the effective shut down of one of the world’s largest economies. The government there states that 908 people have died from the disease and a total of 40,171 have been infected. As of 9th February, the World Health Organisation had confirmed the disease had spread to 26 countries.

Territories with confirmed cases of 2019-nCov:

Source: Al Jazeera

Given the severity of the situation, the strength in the equity markets may surprise many. Those who missed the chance to buy the dips, for example on 31st January, might be feeling some regret. Between that date, when S&P Futures (CME:SP1!) posted a yearly low of 3,214, the index rallied 4.2% within the next six trading sessions.

S&P500 Futures — (CME:SP1!) — one-month price chart:

Source: TradingView

The feelings associated with FOMO can linger in a trader’s mind and the situation is not helped by there being relatively few similar buying opportunities. A long-term and gradual rise in the markets, such as that seen since 2009 is a tide that lifts all markets, but more active traders have not been presented with an abundance of opportunities to ‘leg-in’ to a long position.

S&P500 Futures — (CME:SP1!) — 15-year price chart:

Source: TradingView

The divergence between the price of oil and equities has been triggered by the same event. The different market interpretations have caused the two assets to react quite differently. The three-month price chart for S&P500 vs Light Crude futures shows that through the tail end of 2019 the two were closely correlated.

Oil vs S&P500 (CL1! vs S&P500) — Three-month price chart:

Source: TradingView

The 12-month chart comparing the two shows the peaks and troughs in oil reflecting the higher volatility levels of the commodity, but the long term trend is not the same at the divergence shown over the last month.

Oil vs S&P500 (CL1! vs S&P500) — 12 month price chart:

Source: TradingView

Oil vs S&P500 (CL1! vs S&P500) — One-month price chart:

Source: TradingView

The underperformance in oil highlights how a global slowdown in trade and freight would impact demand. Buyers of equities have formed the opinion that the ability to adapt and find alternatives might not impact that part of the corporate world to the same extent. The divergent move shown in the charts could be a trading opportunity. One possibility is that the coronavirus outbreak will lead to a paradigm shift in the global economy. The more likely outcome is that oil will recover from the shock event as agents of supply and demand adjust to the news. Few would bet against the second scenario. The long-term price chart shows the over and undershooting being played out. Finding an entry point that allows trades to take flight before getting stopped out is, as ever, the more challenging part of the process.

Three major variables are still in play. The first is whether public health measures will continue to steer the coronavirus outbreak away from the worst-case scenario. The second relates to the fundamental drivers of corporate performance, whether corporations will manage to meet the challenges posed by the outbreak. The third is interest rates and the market taking the view that central banks will set the price of money as low as it needs to be to ensure assets, and equities, in particular, remain buoyant. Those looking for the next trigger points will note that there is scope for each of the three to work in unison or for a combination of outcomes.

 

Containment

With a vaccine some months off from being available, China has demonstrated how it is easier to introduce radical public health measures in nations with a greater degree of state control. Countless anecdotes detail the force the government has applied to restrict the spread. Traffic controls in Beijing have been relaxed to allow citizens there to drive rather than use public transport. On Sunday, Wuhan authorities banned all car journeys to stop people moving through the city. There is also the nationwide policy of extending the Lunar New Year national holiday.

Speaking on the subject, Yanzhong Huang, a senior fellow for global health at the Council on Foreign Relations, made specific reference to the 1,000-bed hospital built in Wuhan to house the infected. Describing how the China administration can literally bulldoze their way through a city he said:

“This authoritarian country relies on this top down mobilisation approach. They can overcome bureaucratic nature and financial constraints and are able to mobilise all of the resources.”

Source: BBC

The number of confirmed cases in China appears to be levelling off, but the news flow to monitor is that of Western countries, which, due to cultural differences, are required to apply a different approach. Monday saw four more confirmed cases in the UK as the country doubled its count of confirmed cases to eight.

UK Health Secretary Matt Hancock has announced measures to protect the public from the transmission of the virus. The official statement released on Monday read:

“The Secretary of State declares that the incidence or transmission of novel Coronavirus constitutes a serious and imminent threat to public health… Measures outlined in these regulations are considered as an effective means of delaying or preventing further transmission of the virus.”

Source: CNBC

Western populations will need more carrot than stick if they are to be as effective at restricting its spread. Research by Gabriel Lung and other team members at the University of Hong Kong estimates that the outbreak may peak between late April and early May. Traders would do well to note the question relating to the spread of the epidemic through other countries appears to be a question of ‘when’ not ‘if.’

The downward pressure on the oil price appears to be factoring in the virus making serious inroads into other countries. Trading near its long-term support of $50, there will be many looking to pick the bottom in this area. Two plausible scenarios to support that trade are the virus not spreading as much as anticipated — and the Chinese government aggressively kick-starting the China economy as soon as there is some kind of medical all-clear. With suppliers looking to scale back at these prices, oil could, within the next few weeks, find itself experiencing a short squeeze as producers and consumers once again fail to coordinate their timing.

 

Fundamentals

Monday has seen some of China’s population return to work after the extended Lunar New Year holiday. Extending the national holiday by 10 days may have stifled the epidemic, and basing decisions on that foundation even today, many firms remain closed or have instructed its staff to work from home. Office-sharing firm WeWork announced on Monday that it is temporarily closing 100 offices in mainland China.

The production line involved in manufacturing iPhones has become a bellwether of the rate of economic recovery. Most recent reports show that Foxconn, Apple’s biggest iPhone maker, won approval to resume production in the eastern central Chinese city of Zhengzhou. Less positive news is that only 10% of that factory’s workforce has managed to return. In the southern city of Shenzhen, the local authorities have rejected a company request to resume work there.

Demand for oil is based off relatively binary formulae. As levels of freight and manufacturing have fallen, so has the price of crude. While modern production techniques may be more complex, this does allow for contingency planning. The hope for those long equities is that necessity will be the mother of invention. A clear understanding of the situation may not be possible until corporate announcement or earnings numbers are released.

Trying to get ahead of that curve could involve taking the same approach as Patrick Chovanec, the chief strategist at the investment firm Silvercrest Asset Management and an expert on the Chinese economy. Comparing the economic effects of the epidemic to those of a natural disaster, his indicator of the long-run economic importance of the chock event is the duration of the disruption to business. Speaking with Intelligencer, he said:

“If you have a factory that’s shut down, and it’s shut down for a week because of a cyclone, then next week you’re just going to use more capacity to meet your back orders; the actual amount of economic activity and output isn’t diminished hardly at all… If things go on for an extended period of time, you actually start to lose orders.”

Source: Intelligencer

Analysts looking to get back to researching underlying data relating to the health of the global economy may be disappointed. Chovanec’s analysis once again points towards a need to consider the spread of the virus and the comments of epidemiologists.

 

Inflationary boost

The non-farm payroll numbers released on Friday once again showed the economy beating forecasts. US unemployment fell for the fifth month in a row, which ticks the box for the US Federal Reserve in terms of jobs targets. Payrolls surged 225,000 for the month, well above Wall Street estimates of 158,000. Despite the impressive job numbers, there is still a belief in the equity markets that despite the risk of wage-push inflation, any impact from the coronavirus will be ameliorated by cheaper money being made available.

Interest rates may be near zero, but the Fed’s intervention in the money markets is quantitative easing in all but name. The consensus is that scaling up that program would be too tempting for the Fed to resist. The European Central Bank is already engaging in an open-ended QE program. The measures introduced by ex-President of the ECB, Mario Draghi, means that since November, the ECB has been pumping €20bn into the markets each month. With 2020 also being an election year for US President Donald Trump, it is an unlikely time for him to lobby for prudence from Fed Chair, Jerome Powell.

The Philippine central bank cut interest rates on Thursday, following the Bank of Thailand’s response to the coronavirus outbreak. The trend is for Southeast Asian countries to enact monetary easing in response to the epidemic. While the US Fed and ECB have much greater critical mass than those other central banks, they share the same dilemma. The equity market reaction confirms that the expectation is that further monetary easing will be carried out if deemed ‘required.’

Traders with leanings toward the bears and bulls in both equity and oil markets can pick out a variety of potential trigger points. The trick will be as much down to getting the timing right as it is to getting a trade on in the right direction.

 

Indicators

Technical indicators such as Average True Range (ATR) may come to the fore. ATR is firmly in the category of ‘supporting indicator’ rather than that of ‘lead indicator.’ The ATR of the SP500 hourly chart has fallen away through the course of Monday’s trading.

SP500 — Average True Range (14) — hourly candles — 6th February–10th February:

Source: cTrader

This opens up the possibility of a move, on an hourly basis. The lower ATR is seen to be giving price ‘room to breathe’. The chart using daily candles shows the extra price volatility over the last few weeks, which indicates that a lot of the price moves (on a daily basis) may have taken place, for now at least. Any price consolidation and a drop off in ATR would throw up the potential for the SP500 to make its next move.

SP500 — Average True Range (14) — daily candles 5th December — 10th February:

Source: cTrader

The ATR is a predictor of the likelihood, rather than direction of any price movement. Entry and exit points should not be designed using the ATR alone. Given that trading a rebound in oil would be going against a significant trend, using the ATR in conjunction with other more directional indicators may help with trade timing.

Moving Average Convergence Divergence (MACD) is a perennial favourite and could help pick the end of the current trends. Being a trend-following momentum indicator, the signals should be particularly useful in current conditions.

SP500 – Moving Average Convergence Divergence (MACD) (26, 13, 9) — daily candles 5th December–10th February:

Source: cTrader

The cross-over MACD used in the above chart picks out an interesting yellow/red cross-over on the daily chart.

The chart for the one-hour candle shows a yellow/red cross-over as Asian markets closed and the European market opened.

SP500 — Moving Average Convergence Divergence (MACD) (26, 13, 9) — hourly candles 6th February–10th February:

Source: cTrader

 

Testing

Live positions always focus the mind. Even bad trades can flag up which indicators are and aren’t working in current market conditions. The below table from MT4 shows how two test-trade long positions have fared. Both were executed at the same time, half-way through Monday’s European trading session. The CRUDE_MR20 is treading water. The NASDAQ _M20 is showing a profit of £3,722

Source: MT4

It’s always nice to show a profit, but more importantly, there may be some time until the tide turns, and oil outperforming equities becomes a trade worth scaling into. Price action around the crucial support level $50 support will be key to timing any entry.