Record Streak For Nasdaq 100

I am attempting to contextualize the recent rally in tech stocks. In doing so there will be some bearish points and some bullish points. Also, keep in mind that some tech stocks have better fundamentals than others. I consider it to be bearish when new records are made in terms of valuations or winning streaks and bullish if this market isn’t acting unusual. The chart below is an example of the former. As you can see, the Nasdaq 100 ETF has had its longest streak above its 50-day moving average since 1998. That includes the end of the technology bull run. As you can see, the third longest streak was in 1999 and 2000. On the bright side, the current streak only led to a 19.6% return, which is the 7th best streak in this chart.

Frackers Feel The Pain

My bearishness on oil has been successful this year, but it doesn’t mean that we should ignore the bullish case for it. The chart below shows the recent survey from the Federal Reserve Bank of Dallas on the frackers’ breakeven rates for drilling new wells. It’s important to emphasize that this was done in March, so the cost cutting to get the lowest breakeven rate is baked into these responses. As you can see, the breakeven costs are somewhere between the mid-$40s and the mid $50s per barrel. The current price of oil is below all these breakeven rates which means oil’s long-term price is probably higher than where it is now. Oil is very volatile because it takes long to start and stop production. For example, if oil is rallying to the $70s, it would take time to catch up to demand, which would keep it going higher for a while. Finally, when production catches up, it would balance the market. Eventually, the market will get oversupplied which will cause production to be cut too much. We’re about to see production cuts in the next few months as oil falls into the low $40s and possibly the high $30s. This would work perfectly with my thesis that oil firms will have their profitability fall in the 2nd half of 2017. Profits will fall when prices fall and then profits will fall because of production cuts.

Looking at the time line for production cuts, the chart below shows the price of oil, the price with a 6-month lag, the price with a 12-month lag, and shale production. As you can see, the shale production mimics the 12-month lagged prices because of the time it takes for drillers to change their plans. Costs are lower for wells that are already drilled, so those stay on line. Also, when a firm has a contract which is locked in at a higher price, they keep drilling. The new production must make up for those wells which are not price sensitive.

As you can see, the lagged prices are now starting to fall. The longer they stay depressed, the more likely production will stop. Management at these fracking firms get paid to find new oil and gas and drill as much as possible. There needs to be severe pressure, meaning prices need to stay low, for production cuts to be made. You can see the yellow line’s slope declining. The next step is for it to fall. It will be interesting to see how OPEC reacts to this. Yes, they are getting frackers to feel the pain and lower production, but this decline in oil is also painful for them. When OPEC decided to maintain its cuts, everyone was declaring victory for shale, but if oil stays this low, they will declare victory for OPEC. It’s like a heavyweight bout.

M&A Down Sharply

As you can see in the chart below, the global value of M&A activity has been falling lately. Credit conditions are very favorable for deals to be made, but they’re still declining. This cycle has been long, so most of the great deals have already been made. With stock prices soaring, firms may not want to pay these elevated levels to buy public firms. Firms which are acquired usually get bought at a premium, so the buyers must go out on a limb and take high risk with such expensive valuations being the norm. As you can see, the M&A activity usually peaks before the stock market peak. This implies the stock market is about to fall. The one caveat to this is that M&A activity may have fallen because of earnings declines. Now that the earnings recession is over, M&A activity might pick up.

The chart below is a clearer look at the same data in the chart above. By looking at only the first quarter results, we can see the data without the seasonal noise. As you can see, the number of deals declined in Q1 2017 for the first Q1 decline since 2012. However, the total deal size rebounded. This shows that my point about the earnings recession was accurate.

Yield Curve

We’re at an interesting point with the yield curve because it’s getting closer to inverting. The difference between the 10-year yield and the 2-year yield is 81.68 basis points. The reason why I say it’s interesting is because the buying in the 10-year lowers the yield competition with stocks. Part of the reason stocks are so high is low bond yields. Despite the Fed raising rates and unwinding the balance sheet, rates are low. Investors may pour into stocks because of lower rates which could backfire on them if the yield curve inverts and a recession occurs in 2018.

It’s important to note that the ‘money on the sidelines’ meme is bogus because both bonds and stocks are going up now. Bonds provide a reason to pay higher valuations for stocks, but it doesn’t necessarily mean the money must come out of fixed income to go into stocks. If the money actually did move from treasuries to stocks, stocks would soar so much, the Nasdaq bubble of the 1990s would look like a blip.