Why we're no longer that bearish on the S&P 500, oil, and interest rates

Our model has consistently stated that this is a big rally in a bull market. However, various discretionary factors in the past few weeks seemed bearish enough to cause a small correction in stocks:

  1. Oil’s weakness should have hurt the energy sector’s profits.
  2. Falling oil prices should have caused inflation to decline, which would cause interest rates to fall in the medium term. That would lower financial sector earnings growth.

Both of these bearish factors are no longer that important. We did a study which showed that a declining oil and XLE (energy sector ETF) almost always led to a small correction in the S&P 500. There was only 1 exception.
Right now, XLE has fallen a lot while the S&P has continued to rally. The first chart is XLE, the 2nd chart is the S&P.

Perhaps the current case is going to be the 2nd exception.
As you can see in the charts above, the S&P and XLE have diverged since mid-December 2016. In other words, the S&P has rallied for 6 months while XLE has fallen for 6 months.
In all the historical cases that we listed, the S&P diverged from XLE for 4 months at most. The divergence typically lasted 1-3 months. With the current divergence lasting 6 months, there’s a >50% possibility that:

  1. XLE’s medium term bottom is in.
  2. A final spike down in XLE will not be enough to make the S&P fall 6%.

In other words, if XLE was supposed to bring the S&P down, it should have happened already. It didn’t happen.
If that’s the case, then it’s hard to see why oil should crater to i.e. $40 a barrel. Yes, it’s true that U.S. shale’s break-even price is around $37-$38. However, historically the break-even price has been a floor price. Oil doesn’t have to fall to the floor price. Yes, it’s true that U.S. oil production is surging. But that doesn’t mean oil has to fall from $49 to $40. Perhaps it will only fall to $45. Who knows.
If oil doesn’t fall significantly, then it’s hard to see why inflation and interest rates should fall significantly. In that case, oil and interest rates won’t be bearish factors for the S&P 500.

The COT Report

Commercial hedgers are seen as the “smart money” in the COT report. The latest COT Report reveals that:

  1. Hedgers are very bearish on bonds and bullish on interest rates. If the commercial hedgers are right (and they have been right over the past year), it’s hard to see why interest rates should fall significantly.
  2. Hedgers are very bullish on the Canadian dollar. There is a modest positive correlation between the CAD and oil. If the Canadian dollar goes up, it’s hard to see why oil should fall significantly.

First chart is the hedger position on the 10 year U.S. Treasury bond. Second chart is the hedger position on CAD.

Here’s CAD.

Bottom line

We only invest in stocks. We care about other markets only to the extent that they impact the S&P 500.
We don’t understand the oil and bond markets that well. But at the very least, we are no longer concerned that these markets will hurt the S&P 500.
We remain in 100% cash simply because this “small rally” has gone on for too long. We’ll switch back to being 100% long UPRO (3x S&P 500 ETF) when the S&P makes a small correction and falls 6%.

Leave a Comment