The Market Price Action The Last Two Days Tell You Everything You Need To Know About Where We Are Headed
Last week, we published an article titled, "This is Where I Think the Market is Headed." If you had not had a chance to do so, please read it now. The market price action over the last two days has not only validated our initial analysis of how the market is treating inflation, the Fed, and oil, but it has reinforced our conviction that this was truly a "massive" bear market rally.
To clarify once again, we believe there are two prevailing market narratives in conflict today:
The Fed is successful in fending off inflation or unsuccessful.
Oil price demand destruction vs oil price demand rebound.
Looking at the market reaction to the CPI print of 8.5% yesterday, it told me the following:
Nasdaq staged a massive rally as investors expect inflation to have peaked, and as a result, the Fed will slow down the rate hikes.
But I need you to step back for a minute and think this through. One of the key reasons why CPI disappointed to the downside was because energy prices fell materially month-over-month. And the key reason why energy prices disappointed to the downside was that high oil prices resulted in demand destruction.
Given that elevated price was the reason for demand destruction (not the Fed's interest rate hikes), then the opposite logic also applies. Lower prices will help stimulate demand. This is precisely the yo-yo supply and demand dynamics we talked about in this write-up in June. Here's what we said:
Because the market is wrong about what the Fed is capable of on the inflation front. The reality from the fundamental supply and demand of things is that the oil market deficit we are seeing won't end just because the Fed raised interest rates. We are talking about physical commodities here, so without proper capital investments, you won't get the needed supply.
What the Fed may induce in the short-run by jacking up interest rates is by lowering oil demand. But over time, consumers adapt, growth resumes, and oil demand picks back up. As we've said many times over the past few weeks, if high oil prices are the result of the recent demand slowdown, then low oil prices will just push oil demand back up.
The end result is a yo-yo market going back and forth. For a while, the market may believe that the Fed is effective in fending off inflation. Commodity prices drop, but then because of the price drop, commodity demand picks back up, and yo-yo supply/demand here we go.
That's why this is a bear market for the broader equity market. There's no solution to the commodity market crisis we are seeing, and this is especially the case with the oil market. The only reason why I'm cautious about oil in the near term is that prices are high enough to dampen demand. But when prices fall, demand picks back up, and the deficit will worsen.
Now that we've taken a step back and thought this through, the question for everyone going forward is when will oil demand start to rebound? Our analysis based on the data published by EIA yesterday suggests that demand is already rebounding. The crude + 3-2-1 crack of $130/bbl is where it's becoming supportive of demand. In addition, global refining margins have staged a full reset allowing for further demand recovery in non-OECD countries.
We can validate our assumption/theory by 1) paying attention to global refining margins going forward (they should be going up) and 2) paying attention to what the EIA reports.
Once the market sees what we see, demand is bottoming, then oil prices will start to go back higher further pressuring inflation. This will, in turn, result in the market realizing that inflation has not peaked and that the Fed will have to continue increasing interest rates. The end result will be where energy starts to massively outperform tech.