An ancient Wall Street saying advises, "Don't catch a falling knife." Another ancient Wall Street saying observes, "Markets make opinions." Both of these sayings pertain to the stock market's pathetic oil and gas sector.
First, let's talk about those falling knives. They look something like this:
As the price of crude oil has collapsed during the last three months from $100 a barrel to nearly $50 a barrel, the shares of oil and gas companies have also collapsed. Both the
SPDR Oil & Gas Services ETF (NYSE: XES) and the
SPDR Oil & Gas Exploration & Production ETF (NYSE: XOP) have tumbled more than 40% since early September and are hitting fresh four-year lows almost every new trading day.
The investor who sticks out his hand to catch these apparent bargains may lose a finger or two, financially speaking.
The risk with falling knives is not necessarily that they
deserve to fall ever lower; it is rather that their downward momentum is so powerful they tend to fall well below "fair value" before bottoming out - hence the adage against catching falling knives.
But falling knives can be very alluring, especially to contrarian investors. The knives in the oil and gas sector are no exception. At their current quotes, both SPDR Oil & Gas Services and SPDR Oil & Gas Exploration & Production are trading at more than 40% below their five-year average price-to-cash flow levels. And neither one has ever been cheaper, relative to the S&P 500 Index.
Of course, there's a reason for these "bargain valuations." The oil price is in freefall, as OPEC's refusal to cut production raises the prospect of a supply glut.
But here's where our second Wall Street expression comes into play: "Markets make opinions."
It's true that OPEC has refused to cut its production and that U.S. production has reached its highest level since
The Godfather won "best picture." It's also true that global demand for crude oil is falling slightly short of this robust global production.
These data points are, indeed, bearish for the oil price... and are a big part of the reason the oil price is falling.
But cold, hard facts are not the
only bullies in the oil sector. Opinions are also smacking oil around. And the lower the oil price falls, the more hostile those opinions become.
In other words, markets make opinions.
But here's the thing: An opinion that begins very logically can sometimes take on a life of its own, and in the process lose all connection to underlying realities... and become woefully misguided.
For example, at the top of the housing market in 2007, the market made the opinion that houses were a permanently great investment. Then, at the bottom of the housing market in 2010, the market made the opposite opinion.
Expressing this widespread opinion,
Time magazine published a September 2010 cover story, titled "Rethinking Homeownership: Why owning a home may no longer make economic sense."
"Homeownership has let us down," the cover story lamented. "For generations, Americans believed that owning a home was an axiomatic good... A house with a front lawn and a picket fence wasn't just a nice place to live or a risk-free investment; it was a way to transform a nation... [But] The dark side of homeownership is now all too apparent: foreclosures and walkaways, neighborhoods plagued by abandoned properties and plummeting home values... If there ever were a time to start weaning America off the idea that homeownership cures all our ills, now.. would be it."
As we now know, that opinion was just as wrong as the opinion in 2007 that housing was a great buy. [To learn more about how often "obvious" opinions turn out to be completely misguided,
check this out.]
Today, the market is of the opinion that oil and oil stocks are a bad investment. Oil and oil company stocks are for
selling only, not for buying. The lower the oil sector falls, the more pervasive and entrenched this negative opinion becomes. It's a vicious, self-validating cycle.
But the prevailing opinions about the oil market may be far direr than the actual realities.
For example, according to prevailing opinion, the oil price is in freefall because of a supply glut. And yet, based on the latest data from the U.S. Department of Energy (DOE), U.S. inventories of crude oil and natural gas are both
below where they were one year ago. And as the chart below shows, no obvious or immediate correlation exists between inventory levels and oil prices.
When inventory levels were rising in late 2012, for example, the oil price was also rising. Then, over the ensuing two years, the oil price hung around the $100 level, no matter what inventory levels were doing.
Fast-forward to the present: Crude inventories have been declining for months, which should provide support for the oil price, all else being equal. Instead, the oil price is tumbling.
Is it tumbling because the news and data in the oil sector are so thoroughly awful, or is it tumbling because the opinions about the oil sector are so thoroughly awful?
Let the reader decide, but before deciding, let the reader remember that markets sometimes make opinions that veer far away from underlying realities.
That's when great buying opportunities (or selling opportunities) emerge.
It may not be time just yet to load up on energy stocks. But as The Oxford Club's resident natural resources expert Sean Brodrick observed
a few days ago, "You should be making [a] shopping list... The world is using more energy all the time, and we may be coming to a once-in-a-decade sale in the best [energy] stocks. If history is any guide, energy stocks will bottom well before the prices of oil and natural gas head higher."
Good investing,
Eric J. Fry
for Free Market Café
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