Higher Oil Prices are the Real Problem. Is This Temporary? Another Key Reversal Day.

For the most part, stock markets have moved three steps forward and one
step back. This is the way it has been in the past and this is the way it will likely
to be in the future. It is very likely that this is just like one more of the hundreds
of “steps back” that have occurred since stock markets first began trading.

 

At a time like this, it is important to put current events into perspective. For
example, how does the issue with Russia and the Ukraine compare with the 2001
invasion of Afghanistan by the US and UK, with the 1990 invasion of Kuwait by
Iraq, the 1991 US invasion of Iraq in operation Desert Storm, the US invasion of
Grenada in 1983, the 1983 US embassy bombing in Beirut that killed 241
American service members, the September 11, 2001 terrorist attacks, the Iranian
threat to obliterate Israel, the Chernobyl nuclear disaster, the Chinese crackdown
on Hong Kong, the 2016 invasion of Syria by Turkey, the Russian invasion of
Georgia in 2008, the Russian invasion of Chechnya in 1994, the Russian invasion
of the Ukraine in 2014, the 1980 invasion of Iran by Iraq, the Israeli invasion of
Lebanon in 2006, the trade war with China? You get the picture. Looking back at
history reminds us that this is not the first time there has been similar military
action. It is also important to acknowledge that these are just some of the issues
that have faced investors since 1980 while the DJIA rose from 1,000 all the way
to 37,000.

 

We have also learned that invading a country with a large powerful army is no
guarantee of success! The Americans withdrew from Vietnam and the Soviets
were forced to withdraw from Afghanistan. US and British armies just withdrew
from Afghanistan last year. Putin is taking a big gamble with this advance while
the people in the Ukraine will be supplied with sophisticated weapons and
intelligence from the west.

 

While there is always uncertainty when an invasion like this occurs, we must
look at what is really important. The global economic implications of this move
appear to be minimal. However, what does have major implications to the global
economy is interest rates and oil prices. While the actions by Russia is not
affecting interest rates in the US or Europe, it has happened while oil prices have
increased to the highest levels since 2014. Higher oil prices are like an extra tax
on every person in the world. Everyone is affected in some way by higher fuel
prices so there is less money to spend on other things. Therefore, this is a concern.
Many wonder what this means for the future of oil prices. However, those who
understand history and long-term cycles have a perspective that has offered sound
guidance for what should happen to oil prices.

 

The December 9, 2014 Investment Update looked back to see how oil prices
reacted in the previous consolidation phase from 1980 to 2000. Based on the
percentage decline in oil prices over that period, I concluded, “If oil markets
follow the pattern of the 1980’s and 1990’s, prices could reach a low soon and
then trade in the $40 to $80 range for the next 13 years or so before falling to
the second and final low.” Indeed, the chart below shows oil prices did fall from
over $100 when that Update was written in late 2014 down to $38 a barrel in
early 2016. Oil prices collapsed briefly in 2020 and are now above $80.
However, if you look at this chart, you will see that oil prices have traded
between $40 and $80 for most of the last eight years. If history repeats, oil
prices should continue to trade in this range many years into the future.

 

It is also important to remember that oil prices briefly spiked to all-time
record highs of $40 when Iraq attacked Kuwait in 1990 during the previous
consolidation phase. That was not the beginning of a long-term rise in oil prices.
In the same way, a brief spike in oil prices half way through this consolidation
phase would just match what happened when oil prices were in a long-term bear
market from 1980 to 2000. (The chart below is from oilprices.com) At this time,
we all have a choice. Are we going to rely on history, which has been accurate
since 2014, or on human logic? You know what my choice is.

 

 

The January 24, 2022 Update showed that a key reversal day had just occurred.
A key reversal day is when stock prices fall sharply during the day and then close
with a gain. That happened on January 24th. These huge sell-offs and reversals
usually occur with heavy trading volume too. A key reversal day is a sign that the
selling is exhausted for the time being. Therefore, a key reversal day can signal
that a market bottom has occurred. However, sometimes markets need to form a
double bottom to eliminate the last vestiges of over optimism. Double bottoms
usually occur four to eight weeks apart. Usually the second low is within 4% or so
of the initial low.

 

This is exactly what happened on Thursday, February 24th. The S&P 500 was
down as much as 2.5% as Russia invaded the Ukraine, but closed up 1.5% on the
day. The S&P 500 traded in a 4% range. The trading volume during the reversal
day on Thursday was the fifth highest since the start of 2021. The trading volume
on January 24th was also one of the top five trading volume days in the last 14
months. These lows occurred 4 weeks apart and the closing lows were within
2.6% of each other, matching the patterns human behaviour have created at
previous market bottoms.

 

We must remember that the news does not have to turn positive for stock
prices to rise. Conditions do not have to change right away either. The most
obvious example was when stocks rose month after month following the March
2020 Covid sell-off. For much of 2020, many could not understand how stock
prices could rise in the face of so much bad news and uncertainty. However,
markets bottom when the selling is exhausted, not necessarily when the news
changes. There is a saying that stock markets “climb a wall of worry.” There are
concerns about interest rates and the Ukraine so there is worry. But if the selling
has been exhausted, as the key reversal days suggest, this correction could be
over. If it is not over now, it should be soon. If stock markets are higher a week
from now, it would provide strong evidence that a new uptrend is starting as
markets again climb another wall of worry. Please see a chart of the S&P 500
from WSJ showing the double bottom below.

 

The latest data from Investors Intelligence shows that optimism has declined so
that there are only 1.2% more bulls than bears. II states that it is a strong buy
when this level is at 0% or below 0%. Please see the chart below.

 

Five years from now, are you going to be looking at your portfolio and
wondering how it performed in February 2022? I will leave you with some wise
words about how to handle times like this.

 

This is what Warren Buffett wrote in his 2017 letter to shareholders. “Even if
your borrowings are small and your positions aren’t immediately threatened by
the plunging market, your mind may well become rattled by scary headlines and
breathless commentary. And an unsettled mind will not make good decisions.”
An investment commentator wrote, “Its also important to remember that the
value of your portfolio is a number on paper, not money that’s in your pocket
right now. They’re intentionally called unrealized gains and losses. It’s not
official or real until you hit the sell button, then you have realized your gain or
loss and it’s done. It just goes back to that point of having perspective.”

 

Legendary mutual fund manager Peter Lynch said, “The way to make money
in stocks is not to be scared out of them.” Market action in the coming weeks
should provide valuable indications of what should happen in the months ahead. I
will continue to keep you informed. Have a great week my friend!