I hope that you had a good, shortened week after the Labor Day holiday. For me, I was dealing with COVID-19, which came on abruptly last weekend and left as fast as it arrived (thankfully).

Post-Holiday Market Malaise

I find it interesting that a lot of analysts and talking heads made mention this week of the "holiday hangover.” That’s where people still feel like they are on vacation and may be reticent about taking action on their investment portfolios.

The markets were negative until Friday, and then they closed up but were still down for the shortened week. We think the specter of higher interest rates for longer, along with climbing oil prices, made investors cautious when they considered that inflation might tick up and fuel more hawkish rhetoric from the Fed.

Putting a pencil to stock valuations with continued headwinds is causing some hesitation by money managers and investors. These factors, and the dreaded fear of the worst month in the markets, caused active money managers to raise cash and become more defensive during August and into September.

NAAIM: Active Manager Exposure to Equities Fell to 49.7 From 61.2 During August into September

Global Growth to Slow

Leaders of the Group of 20 nations are meeting this weekend in New Delhi without two of its biggest participants: China and Russia. They are set to issue a communique telling the world that economic uncertainty remains high - thanks in part to “cascading crises” that have presented obstacles to long-term growth. The group will warn that the balance of risks to the global outlook is tilted to the downside.

Additionally, the International Monetary Fund warned in April that its outlook for global growth over the next five years was the weakest in more than three decades. It urged nations to avoid economic fragmentation caused by geopolitical tensions. It seems that the G-20 (sans China and Russia) may be similarly pessimistic. Two of the most prominent players not attending will also cause additional geopolitical risks, we fear.

Today, we want to focus on the headwinds that higher oil, interest rates, and the U.S. dollar may cause. Moreover, higher energy prices, especially felt by all Americans at the gas pump, may force the hand of the Fed to continue raising rates as they desperately try to stop inflationary forces.

Bring On the BRICS

The BRICS nations were originally made up of Brazil, Russia, India, China, and South Africa. Recently, these countries went through an important and powerful expansion. Bringing additional oil-producing nations into the mix was a big win.

The addition of Egypt, Ethiopia, Argentina, Iran, and the United Arab Emirates, many believe, makes this group of countries more powerful than the G-20. This may be part of the reason that China and Russia did not participate in this weekend’s G-20 activities in India.

Therefore, it was no surprise this past week when Saudi Arabia announced that they would continue their 1 million barrel-a-day production cut originally announced in July. They, along with other OPEC nations (including Iran), have successfully driven the price of oil up to new 52-week highs in 2023.

More damaging is the prospect that higher oil prices will not only keep interest rates high, but probably force the Fed to take rates to 6% or higher as they try to balance steady growth with an uptick in inflation.

This is no surprise to us that inflation would likely slow and then experience an uptick, similar to what happened in the 70's. While the economy is on a steady growth trajectory for the moment, it is vulnerable to slowing dramatically as we enter 2024. Then the evil stagflation may begin to creep in with its insidious consequences.

We need to remember that next year is an election year, and this administration will do everything in their power to keep the economy out of a recession. That would be unpopular and likely cost them the White House.

Let’s explore some headwinds, starting with oil and the energy complex.

US Crude Oil Inventories

Including the SPR (Strategic Petroleum Reserves, which were used by the Government in 2021-2022 to try and lower oil prices), this is the lowest level of total crude inventories in America since 1985. This is very dangerous for a nation depending on oil and oil-related products.

Permian Production has Slowed

The most active oil-producing basin in the U.S. is now experiencing a contraction in the number of operating rigs. Keep in mind that the Permian basin accounts for nearly 40% of all production in the U.S.

Supply is falling and demand is rising. As we have come out of the height of the pandemic (2020-2021) and people are now returning to their offices nationwide, the demand for gasoline is rising. We are now at a point where supply is falling. Much of this is due to production cuts along with other countries increasing their demand.

In the U.S., crude stockpiles continue to fall. The Energy Information Administration (EIA) reported commercial crude inventories in the U.S. dropped by over six million barrels this past week, marking a fourth straight weekly drop that has left inventories at their lowest level since December (dark blue line in the chart below).

On the demand side of the equation, China continues to import more oil (see grey bar chart below). In August, they imported 52.8 million tons of crude oil, or 12.5 million barrels per day, marking a 21% increase compared to July. In the U.S. implied oil demand reached multi-year highs (orange line below) in July before pulling back modestly last month.

A current perspective related to oil prices and other economic headwinds:

The picture above was taken in April 2020, the same month oil prices hit $40 per barrel. Now the national average gas price is $3.93, a 362% increase in just three years, as oil prices near $90 per barrel. If you have a car that needs high octane (92 or greater) and you find yourself purchasing Ultra or Supreme Unleaded, you are paying prices that are likely getting close to $5 a gallon.

Since that picture was taken in 2020:

1. 300 million barrels of oil have been depleted from U.S. reserves.
2. The U.S. Strategic Petroleum Reserves (SPR) now stand at their lowest since 1883.
3. In May 2020, before the SPR depletion began, it held a record 92 days of supply. The historical average is 65 days of supply. We are now 50% below the peak and 29% below the average. This is not a good situation.
4. Interest rates are up over 500 basis points. Rates continue to rise. Why are rates still rising if the Fed is done hiking?
5. Inflation hit its highest levels since 1980.
6. The average interest rate on a 30-year mortgage rose to 7.6% this past month, the highest since 2000.
7. Mortgage demand just hit a 28-year low, and existing home sales are at their lowest since 2010.
8. U.S. credit card debt hit a record $1 trillion.
9. U.S. debt is now at $32.7 trillion, up a massive $1.3 trillion since June 2 of this year. That means the U.S. had added $13 billion per day to the national debt since the crisis ended.
10. Daily U.S. interest expense is set to cross $3 billion, over $1 trillion per year. The debt crisis is far from over.

What happened to inflation being just transitory?

Oil’s Winning Streak

WTI has risen in price for nine straight days. This is a meaningful statistic as this has only happened 7 previous times since 1983. Below is a chart showing each of these times. Look closely at what happens to the price of WTI oil in the future by six and 12 months. This is an ominous sign for consumers. This just might be the cause of a recession.

Oil Prices in the Futures Markets

Tightening oil market conditions have also shown up on the futures curve. WTI time spreads between front-month and second-month futures contracts have been climbing higher in positive territory (technically switching from contango to backwardation in July, pointing to an uptick in near-term demand for oil).

In terms of upside, the next major area of overhead resistance for WTI appears to be set up near the $94 to $97 range, which traces back to the August-November 2022 highs and a key Fibonacci retracement level of last year’s bear market in oil.

Also, take a look at the performance of the XLE during 2023 (it’s interesting how often lately I see analysts recommending investors short XLE and other energy related stocks. My suggestion: don’t).

Also, one of our investment strategies that utilizes ETFs has owned USO since Aug. 9 and is currently sitting on a 4%+ profit. Our algorithms usually select emerging and/or trending themes early on.

Soft versus Hard (Recession) Landing

Heading into a possible recession, the Energy Sector leads the S&P 500. Around soft landings, currently predicted by many economists, energy often lags. However, oil’s late-cycle performance, as we are witnessing now, can cause a recession. For a clearer picture of how energy performs versus the S&P 500 during different types of economic distress, take a look at the following chart.

What Stocks Do Best When Oil Prices Rise?

Value and, to a lesser extent, small-cap stocks tend to outperform when oil prices rise.

An interesting tidbit about electric vehicles that we stumbled upon: If you want to know how quickly electric vehicles might spread across the U.S., just take a look at California. In the past five years, EVs have gone from 2% of new-car sales in the state to 22%.

The pace of adoption in California picked up significantly once EVs reached 5% of new-car sales, a threshold at which preferences start to flip for mainstream car buyers. California was one of the first major car markets to reach that tipping point in 2018, and 23 countries have been added to the list so far.

Growth Has Been the Big Winner in 2023

As we stated earlier, the markets have been negatively impacted this past week by the price of oil rising. Energy related stocks held up well during this past week along with Utilities (energy related). Value stocks did a bit better than growth. Both were down slightly.

Growth stocks have been the big winners during 2023. The Vanguard Growth ETF (VUG) is up 34% as of last Friday. Value stocks have gone nowhere, as evidenced by the Vanguard Value ETF (VTV), which is up 1.6%. This is one of the biggest discrepancies we have seen for any eight-month period.

Look at the chart below comparing Value against Growth. You will notice the blip up in value the past month, which corresponds to oil and Energy stocks beginning to rise. You may also notice that the MACD is becoming more positive after an eight-month negative period.

Growth is Expensive - Value, Not So Much

Clearly, this has been the year of the mega-cap growth stocks taking center stage. Much of it could be attributed to the AI narrative. Take a look at the difference between the 20 mega-cap stocks (and their AI influence) as compared to the bottom 480 of the S&P 500 index.

The top 20 largest S&P 500 companies have added $4.16 trillion in market cap value year-to-date, nearly 9x the amount added by the bottom 480

The Fang (Growth) Stocks have become Expensive

Made up of Facebook (now META), Apple, Netflix, and Google, this group of stocks have gotten expensive using a forward-looking P/E value. FANG stocks have been the darlings of Wall Street this past year.

If second quarter earnings have reached a trough, then value should outperform growth over the next year. This will be especially true if oil prices stay high and the Fed doesn’t raise rates. This combination would fuel a rebound in financial and economically sensitive stocks. Take a look at the chart below that shows a possible slowing in earnings growth moving forward.

Additional Headwinds from a Stronger U.S. Dollar

For the past eight weeks, the U.S. dollar has been on an impressive run. This has taken a lot of wind out of the precious metal markets and kept demand high for money market funds and T-Bills. Some stock analysts have revised stock price targets downward due to the headwinds that a stronger dollar poses for multinational corporations that depend on a weaker, not stronger, dollar for commerce.

The rise in the U.S. dollar could continue based on the following technical chart.

Interest Rates have the Potential to Rise Further

Every day, I hear talking heads tell their audience that “the Fed is done raising rates,” and that their next move is to cut rates. The charts have been telling a different story.

Our algorithms on one of our ETF investment strategies had identified this trend a while ago, when it rotated into a position in the Treasury bond inverse. That trade is profitable. The technical picture of the 10-year Treasury looks bullish for higher interest rates.

The following chart sums up the aforementioned headwinds. What is truly amazing is that these headwinds have not, as yet, slowed down the stock market’s significant rise in 2023. We do have to remember that we are in a pre-election year combined with earnings coming in above expectations.

Investing in Treasury Bills Instead of The Market (S&P 500)

Many investors, especially professional money managers, like to review the earnings yield of the stock market as compared to investing in risk-free assets like Treasury Bills, currently paying over 4% and as high as 5.25%. Today, the S&P 500 earnings yield over cash yield (T-bills) is the lowest since 2000 (-90 bps) and represents a headwind for stocks.

Predictions of a recession have gone up. Below is a chart that Deutsche Bank recently published with their analysis of the prospect of a U.S. recession in 2023-2024.

One bit of good news: We are coming up on the best three months to be invested in stocks.

SPX vs. Fed Cuts

Thanks for reading. We all hope you have a good, profitable, and healthy week. Here is a summary of some other market factors that may have played a part in trading this past week.

Risk-On

• Despite selling pressure this week, volume patterns remain positive across the 4 key U.S. indices.
• Risk gauges remain positive despite this week’s selling.
• Growth stocks held up well and are still in a bull phase.

Risk-Off

• With the exception of the Nasdaq (QQQ), the remaining key U.S. indices all gave up their bullish phases after breaking down this week. The S&P 500 (SPY), Dow Jones (DIA), and Russell 2000 (IWM) are all now in warning phases, with IWM being the weakest as it is barely holding onto its 200-day moving average.
• Sector rotation flipped negative, with Semiconductors (SMH), Transportation (IYT), and Retail (XRT) all down over 3% for the week, while Utilities (XLU) and Energy were the only two sectors up over the past five trading days.
• Market internals flipped negative for the S&P 500 and the Nasdaq Composite, with the McClellan Oscillator on the cusp of a sell signal.
• The two worst performances were in Regional Banks (KRE) and Biotech (IBB), which both moved into bear phases.
• Foreign equities underperformed the U.S. markets this week, with both Emerging and Established foreign equities (EEM & EFA) dropping further below their 200-day moving averages.
• Gold (GLD) is wedged between above the 200-day moving average and below the 50-day moving average, but it looks promising on the longer-term weekly timeframe.
• The U.S. dollar (UUP) continues to set new 2023 highs and is in a bull phase.

Neutral

• The Energy sector was the clear leader this week, as OPEC countries and Russia continue to put pressure on fossil fuels.
• Sentiment indicators were mixed with volatility readings staying positive, yet the number of stocks above key moving averages weakened for both the S&P 500 and Russell 2000.
• Small- and mid-cap stocks dropped this week, while safety plays in large-caps held up well.
• Soft commodities (DBA) continued to outperform equities and is in a bull phase on both price and real motion despite looking slightly toppy in the short-term.
• Oil looks to have a pennant formation on price, which could lead to an even further explosive upside. But at the same time, it is moderately overbought and may need a slight short-term correction before continuing higher.

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More By This Author:

What Might September Hold For The Markets?
The Inflation Fighters: Will They Keep Raising Rates Or Pause?
Higher For Longer - The Pain That Rising Rates Is Causing