ACTV - SP500: Crude Oil Signals An Imminent Recession

2023-11-17 09:24:05 ET

Summary

• The S&P 500 bounced in November, responding to falling interest rates and expectations of aggressive Fed rate cuts in 2024.
• However, it seems like the bounce was just a short covering and FOMO rally, which seems to be fading.
• The falling price of crude oil likely reflects an imminent recession and supports the bearish outlook on SP500 as 2024 earnings growth gets revised accordingly.

The FOMO bounce

The S&P 500 ( SP500 ) bounced sharply in November, primarily responding to the falling interest rates. Specifically, due to 1) weaker than expected jobs data for October and 2) lower than expected CPI inflation for October, the market participants priced not only the end of the Fed's hiking cycle, but also a more aggressive Fed interest rate cuts in 2024. As a result, the long-term rates ( TLT ) fell as well, primarily reflecting the fall in real rates due to the general loosening of financial conditions.

In addition to the expectations of the interest rate cuts in 2024, the general assumption is that the economy would slow, but not enter a recession - which is essentially the definition of soft-landing or even no-landing.

As a result, the bottom-up analysts are still projecting a strong 14.7% earnings growth for S&P 500, which is supporting a bullish sentiment towards stocks going into 2024.

That's the bullish narrative.

However, in my opinion the recent bounce is just short covering and FOMO chasing. This was partially evident in a 6% bounce in heavily shorted small stocks ( IWM ) on the CPI Day.

An imminent recession?

In my opinion, we are facing a recession and thus, the 15% earnings growth for 2024 will have to be significantly downgraded, possibly revised to -15%, as Goldman predicts in a recessionary scenario. Thus, I am bearish on stocks - we are facing a recessionary bear market.

However, the lesson we learned in 2023 is that we need solid evidence that the recession is really imminent. Otherwise, the bearish bets on S&P 500 could be forced to be covered at a loss - short squeeze.

Thus, after the recent bounce it was prudent to evaluate how far the FOMO rally could extend, and not to get in a way. So, there was no follow though for two days. Here's the SP500 chart:

But more importantly, interest rates continued to fall, due to more evidence of a weakening job market. Specifically, on Thursday, the initial claims for unemployment spiked above expectations to a new 12-week high to 231K level - supporting the thesis of more Fed cuts in 2024. Yet, the stock market did not react positively this time, S&P 500 ( SPY ) and Nasdaq 100 ( QQQ ) stayed flat for the day, while Russell 2000 ( IWM ) finished down by 1.6%.

That tells us that the market is now possibly positioning to price the weaker economic data as recessionary. So, here is the chart of initial claims for unemployment.

When looking for the evidence that the market is starting to price the weakening data as a signal of an imminent recession, I looked for the reaction of economically sensitive price of crude oil ( CL1:COM ).

Exactly at 8:30am EST when the BSL released the initial claims data, crude oil was at $76.2/barrel. After the data was released, crude oil started to sell off, ending the day 5% lower just below $73/barrel. There was no other news related to oil that I could find, so I attribute the crude oil reaction directly to the release of the claims data. Here is the chart:

So, what is oil telling us about the near-term economic expectations?

Crude oil has peaked recently just above $95 supported by the OPEC+ supply cuts, and still solid energy demand. The geopolitical situation in the Middle East supported the price of oil at the $80 level. However, once it was clear that Iran would not enter the Israel-Hamas war, the price of oil continued to drop.

The focus shifted from the OPEC+ supply cuts and the geopolitical situation to the prospects of weakening demand. First, there was weakening industrial production data from China, and now it seems like the US is slowing. However, given the sharp 5% drop in oil price in reaction to the spike in the initial clams, it seems like energy traders are concerned about an imminent recession.

Note, the 231K level in the initial claims is still low and suggests a still tight labor market, and not consistent with a current recession. However, the pace of increase in the claims increases the probability that the uptrend in the claims will continue and reach the recessionary level at 300K+ during the first half of 2024.

Yes, there were several "head fakes" in the initial claims during 2023, when the spike above the 260K level reverted back down towards the 200K level. Yet, given the length of the yield curve inversion and the global economic slowing (Japan and the EU are both printing negative GDP) it seems likely that the uptrend in the claims this time is reflecting a weakening US economy, which could ultimately produce a recession.

Implications

It was prudent to monitor how far the FOMO rally would get before making bearish bets on S&P 500. Technically, there was no follow through, although that's still possible if this a just a pause. But what would trigger another leg higher?

The initial (original) trigger of the weaker data and the lower interest rates failed to trigger another leg higher. Instead, the heavy shorted small stocks fell by 1.6%, and the price of oil fell by 5%. This indicates that the market is now possibly starting to price a recession - even if it is just a mild recession. Lower interest rates - lower cyclical commodities - higher gold ( GLD ) - rising USD vs economically sensitive Australian Dollar ( FXA ) - selloff in small stocks - that all spells a recession.

Thus, I am starting to build a short position in SP500. It might not be perfect timing, but you will never get perfect timing. My strategy is to start by selling naked calls on ( SPX ). This is appropriate given Goldman's prediction that S&P 500 stays at 4500 until late 2024, and rises to 4700 after the US election. Well, that's the bullish scenario - the recessionary scenario pegs SP500 at 3700. I think it probably goes even lower.

Note, this is a tactical trade, and not appropriate for most investors. For long-term safer portfolio investment, the 12-mouth TBill yield at 5.25% is very attractive, at least until the "sky's clear".

For further details see: