While 2009 is the year of the Ox according to the Chinese calendar, it would seem that renaming it to the “year of fat tails” would be more appropriate. We have witnessed many events this year that one does not typically see on a day to day basis. For example, how many times does one witness the S&P 500 losing more than half its market cap? There have been times in the past where the S&P 500 will lose 50% of its value, though a decline of that magnitude typically takes place over years. The sell off that occurred in 2008 and into 2009 was truly a generational decline, not only in terms of its magnitude but also its ferocity. The decline in the markets was so quick and dramatic that the S&P 500 was 39.6% below its declining 200 day moving average (200d MA) at the November 2008 lows, and 36.1% below at the March 9th lows. The 2008/2009 decline was the second example of the S&P 500 being more than 35% below its 200d MA in 100 years, with the other example being during the Great Depression.
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Source: Bloomberg
The deviation of the S&P 500 from its 200d MA follows a normal distribution pattern with observations spread around its long term average where 95.4% of observations should be between +/- two standard deviations from the mean.
Normal Distribution
(Percentages represent area under the curve)
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A chart I presented back in April (Possible vs. Probable: "So you're telling me there's a chance!") shows the distribution of the S&P 500 from its 200d MA and the 2008 lows was on the far left of the distribution where there are few observations that far out on the curve.
Oil: Is it a Currency or a Commodity?
In addition to the statistical outlier that the November 2008 and March 2009 lows were for the S&P 500 relative to its 200d MA, there appears yet another statistical oddity, one that is remaining far out on the distribution curve and doesn’t seem to be interested in returning to normal. What I am referring to is the correlation between oil and the USD and the Euro. As the USD was selling off sharply last year it appeared as though oil was acting as an inflation hedge, or anti-USD hedge, as the decline in the USD was fueling commodity prices. You can see this dynamic when looking at crude oil prices which have been moving in lock step to the Euro, which makes up 57.6% of the USD Index.
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Source: StockCharts.com
The movements between oil and the Euro became incredibly linked in 2008 and have remained well above normal values. Going back to 1990, the correlation between crude oil and the Euro has fluctuated between being slightly negatively correlated (-0.20) to slightly positively correlated (+0.20), though this changed in a dramatic way in 2008. Once oil broke the psychological 0/barrel mark speculative fevers began to heat up where the run up in oil prices to 5/barrel was not entirely due to fundamental factors. You can see this below where the correlation between oil and the Euro jumped in the middle of 2008 as the USD was plunging and investors were using both oil and the Euro as a USD hedge. The correlation between oil and the Euro rose as oil broke above 0/barrel, but actually peaked during the deleveraging panic into November as the USD rallied strongly and both oil and the Euro sold off.
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Source: Bloomberg
What is interesting is that the correlation between the two significantly weekened from December 2008 to January 2009, but has since stabilized. Not only has the correlation between oil and the Euro stabilized but it has done so at a still statistically significant level. Below is the standard deviations (Z-score) of the correlation to its historical average, and the spike in November was a 4.049 standard deviation event, an event that should be seen only 0.0026% of the time (enter “Above = 4.049”), or once every 38,461 days or once every 105 years! Quite the outlier, no?
The correlation has weakened since November but it is still nearly 2.25 standard deviations above the mean, which should be seen only 1.2% of the time, so we are still in rare territory. Because we have stabilized north of two standard deviations from the mean ever since January the distribution curve for the correlation between oil and the Euro is being skewed to the right as the distribution curve becomes less of a normal distribution. The tails of a normal distribution curve are supposed to be small as the number of observations in the tail section should occur infrequently, but the higher number of observations lately in the correlation above normal levels is changing the thin tail of the normal distribution into a “fat tail.”
What this would tend to imply is that there is still a high anti-USD link built into the price of crude oil and that it is not completely based of fundamental factors. If it were we should see the correlation between oil and the Euro weaken back into the normal (two standard deviations) range between -0.199 to 0.306, which should contain 95.6% of observations. What the analysis above would tend to imply is to not expect a significant USD-hedge boost to oil prices if the USD continues to weaken to its 2008 lows as much of the USD-hedge is likely already priced in to oil prices. We may already be seeing this as the Euro has broken out to a new high while oil is struggling near the /barrel mark.
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Source: StockCharts.com
Energy’s Turn to Shine?
While crude oil prices are not likely to advance much further than present levels, that is not to say that energy shares may not play catch up. In fact, if the secular bull market in energy is still alive I would expect the energy sector’s relative performance to the broad market to pick up. If it doesn’t, then this would be sending a message to energy investors to pay attention as we are currently at levels that have marked prior bottoms in terms of relative performance. If energy doesn’t turn around soon then the secular bull market in energy may begin to come under attack.
During secular bull market in technology during the 1990s the sector spent more time outperforming the S&P 500 than it did underperforming, with its 12-month relative performance to the S&P 500 shifted up in the image below. In contrast, the secular bear market in technology since the 2000 market top has lead to a shift in the sector’s relative performance into negative territory for most of the decade.
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Source: Bloomberg
In contrast to the technology sector, the energy sector in the 1990s was in a secular bear market and spent most of its time under performing the S&P 500 as its 12-month relative performance spent most of its time in negative territory. That all changed in 2000 when energy took leadership from the technology sector and began to outperform the S&P 500. Since 2000, any time the energy sector’s 12-month relative performance reaches north of 20% a period of underperformance results as the sector cools off from a significant run. Typically, the sector begins to outperform the S&P 500 when its 12-month relative performance returns to neutral (0%) to slightly negative in the -5% to -10% range. Right now the sector has underperformed the S&P 500 by 6.5% over the last twelve months and the recent rally in energy shares may be signaling a turn in the sector’s relative performance, and that the secular bull market in energy remains alive and well after a brief respite.
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Source: Bloomberg
What is encouraging for energy bulls is that if energy is about to begin a period of outperformance, it would be doing so from historically cheap valuations as my energy valuation composite is still below the 2003 lows and the sector remains the cheapest sector in the S&P 500 when looking at the price-to-earnings (P/E) ratio.
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Source: Bloomberg
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Source: Bloomberg
As it now stands the technology and materials sectors are the top two performing sectors year-to-date (YTD), though energy may soon be playing catch up to the rest of the market. While crude oil may not benefit from further USD weakness, energy shares are more likely to benefit as they haven’t kept pace with the USD’s decline nor the rest of the market since the March lows.
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Source: Bloomberg
