Stocks have continued to recover from the horrendous start to the year with the Canadian market leading the parade on the back of a reversal in commodity prices.  U.S. markets have also fought their way back into positive territory for the year, despite weakness in some prior leaders such as growth stocks like Starbucks, Netflix, Apple, Google, Nike and Disney.  Investors clearly ignored the warnings of ‘Sell in May and Go Away’ last month as stocks rose, although the gains were fairly muted.  The Canadian market added to its strong 2016 performance by rising another 1% last month, although the large gains in the telecom, consumer and technology sectors were offset by losses in the basic materials group, which dropped over 14% in May.  In the U.S., the S&P500 Index pushed ahead by 1.5% as it once again tests the prior market highs above the 2100 level.   However, the last 3 attempts to break through that level each failed.  Outside of North America, the European markets recovered nicely from recent weakness with the STOXX50 Index ahead 1.2%.  Japanese stocks rose 3.4% despite reporting further weak economic numbers.  Emerging markets came under pressure though with the Brazilian market off by over 10% last month as the economy remains mired in recession for five consecutive quarters.

North American stocks have been lifted mostly by a flood of new money coming in which has been a mix of hedge funds covering (i.e. buying back) short positions, institutional investors who were underweight resource stocks having to increase their exposure and some of the ‘mountain of cash’ in investor accounts feeling like they were missing some upside in stocks.  The fundamentals underlying stock prices has not improved as earnings growth was still negative in the first quarter and guidance was lowered for the next few quarters in most cases.  Valuations remain near all-time highs and there seems very little room for further interest rate decreases to lift valuations.  But investor sentiment had clearly gotten too negative on stocks, even given the unsettled outlook, and the markets just ‘ran out of sellers.’  That’s not necessarily a good reason to turn around and be a buyer of stocks at these levels, but it does explain the strength we’ve seen since early February.

One sector in particular where the consensus opinion has gone from almost universally bearish to unabashedly bullish is Energy.  The TSX Energy sector has surged over 30% from the January 2016 low, driven by a near doubling in the price of oil from under US$26 to over US$50.  Many of the highly indebted companies used the market strength to raise much-needed new equity, which was eagerly scooped up by large investors who were underweight the energy stocks.  After adding to energy stocks in late January we have been reducing the positions in the last month and have actually moved to short positions in oil and the energy stocks in our hedge fund.  Despite the bounce in oil, the fundamentals remain poor.  A big part of the gain in prices was due to the fact that many financial players had done well with short positions in oil over the past year but were forced to ‘cover’ (buy back) those positions as oil prices rose.  The fall in the U.S. also helped all commodity stocks since these are all priced in U.S. dollars.  But the world remains awash in oil with inventories near record levels and most storage facilities being full.  Some of the excess storage has remained in oil tankers which remain offshore.  The chart below shows U.S. oil inventories.  Despite recent production cuts, storage remains full and inventories are well above the top of the five-year range.   While recent production interruptions due to the Fort McMurray fires and political uprisings in Nigeria could lead to a drawdown in these inventories, the Canadian production is already back on line.

"Sea of Oil" still in storage

There is also a political struggle going on within the OPEC cartel which we think will result in production remaining high from that source.

The bullish case for oil recognizes that oil inventories are at record levels but also expect that falling production and increased demand will move the surplus to a deficit in the second half of this year.   The projections from the International Energy Agency (IEA, shown in the chart below) sees the surplus falling to under 200,000 barrels per day (bpd) in the 2nd half of 2016 from a surplus of over 2.2 million bpd a year ago.  That would lead to a drawdown in inventories and higher prices.

Non-OPEC Production Drop Expected

Our problem with this more bullish view is that it assumes continued growth in global demand, something that we don’t share given that global growth is slowing and energy ‘intensity’ (i.e. use of energy per dollar of production) is in a secular decline.   We also think that the recent gain in oil prices will bring some U.S. shale production back on line as most of those producers have costs below US$40 per barrel and need to produce more barrels to pay down existing debts.  Moreover, Iran continues to ramp up their production now that the international sanctions have been removed.  Finally, there has been a shift of power in Saudi Arabia and we see the new regime as being more interested in gaining long-term market share, particularly versus Iran, than in trying to cut back production.  The simmering market share conflict between those two OPEC power-houses will insure that production remains high.  Bottom line is that we don’t see the production declines necessary to maintain prices at the US$50 level, let alone driving prices even higher.   The problem for the energy stocks is that their valuations, on average, are already reflecting prices in the US$55-60 per barrel level going forward.  The fact that so many Canadian energy companies have raised capital in the past month is an indicator, in our view, that valuations are very extended and these companies are being prudent in opportunistically using this strength to improve their balance sheets and provide more ‘bunker capital’ to get through this period of low prices.

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