How to trade or invest in oil in this market

A couple of months ago, WTI crude oil was selling for more than $100 a barrel. If you would have told a trader or an investor that WTI crude oil would be fighting to reach $50 today, he would probably have laughed at you. But today, traders and investors were cheering oil which saw WTI rise 3.6% to $49.21 a barrel. Is this the sign of a new trend, or is it simply short term noise fuelled by news like what's happening in Yemen? And more specifically, how to turn out a profit trading or investing in oil companies in that environment?

How to invest in oil?

According to traders and investors I see arguing over oil prices on social medias, oil will go down, up, or sideways. Who's right? My answer will both disappoint and relieve you; they are all right. The reality is that asking where oil is going is asking the wrong question. Over long periods of time, we know that oil will fluctuate a lot from undervaluation to overvaluation, that's a fact of the "free" markets. Will oil go up in the long run? Of course it will! But do you have the patience to wait the time that it takes? If you're in for the long run, then buying oil now could turn out to be a lucrative idea. You could also buy puts options as insurance if you're scared oil might go dramatically down. They will protect the value of your shares, as your house insurance protects the value of your home. 

How to trade oil?

If you're a trader, then you don't have months or years in front of you to get your money back. You want your money in, and you want your miney out, with a profit. Why gamble by choosing a direction when you can bet on volatility? Oil volatility is near its peak as you can see on the chart below.

One strategy would be to buy a call option and a put option at the same strike price and same expiration. You would lose your premiums if oil move sideways, but you will make money if oil moves either up or down. However, if your expiration date is far enough, it is highly improbable that volatility will suddently remain flat until your options expire. 

Ask yourself the right question

Instead of trying to guess where oil is going, try to understand your position and what you want to do exactly. Then, adopt the right strategy for your position. Trying to guess day after day if oil will go up or down is a receipe for a lot of stress, frustration, and potentially portfolio disaster. 

Are you ready? CPI, PMI Manufacturing, and New Home Sales

It is said that time goes by faster when you're busy. Well, expect this morning to pass you by like a Bugatti Veyron with all the important indicators that will be released: CPI, PMI Manufacturing, and New Homes Sales. Lets look at how they can impact gold, the stock market in general, and the stocks I'm currently holding.

Consumer Price Index at 8:30

Let's start by the indicator impacting the most consumers; CPI. The Consumer Price Index measure the increase or decrease in consumer prices for a basket of goods. Through the years, the items in that basket change when the Bureau of Labor Statistics recalibrate the value of different items. For example, is the value of a television set 10 years ago the same as today? 

One of the two indicators that the Federal Reserve is watching closely is the CPI. If there's a surprise today and it increases more than expected ( CPI y/y of -0.1% is expected), then it may be a signal for the FED to increase rates sooner. Even if they don't do it, at least that's what investors and traders will think. Therefore, in that scenario we can expect stocks and commodities prices to go down.

PMI Manufacturing at 9:45
PMI Manufacturing is one of the most important leading indicators. It is basically a survey sent to purchasing executives of 600 industrial companies. Expected is a reading of 54.6. If it's higher than that, then again it could scare investors and traders in thinking that the FED will raise rates sooner than expected. In that scenario stocks and commodities prices would go down also.

New Home Sales at 10:00
New Home Sales is similar to Existing Home Sales, except that it only tracks new homes. Analysts expect a reading of 464K new homes sold for this month. New Home Sales is also a leading indicator. Therefore, a better than expected reading could be bearish for stocks and commodities, again because investors and traders would be scared that the FED hike rates sooner than expected.

I personally own Five Below (FIVE), COS.CA (COS.TO), and Tesla Motors (TSLA). If those indicators readings are better than expected it could be bearish especially for FIVE and TSLA how are positively correlated with major stock market indexes.

Existing home sales and what it means for gold and the stock market

Donald Trump once said: "Well, real estate is always good, as far as I'm concerned." This is from an individual point of view of course, but can we expect the Existing Home Sales numbers that will be released at 10:00 this morning to be good? Let's take a look at what we can expect and what will be the impact on gold and the stock market.

Existing Home Sales, for those who don't know, basically track the number of existing homes, condominiums and co-ops that have been sold during the month. It is considered a leading indicator for the economy, meaning that where it goes the economy goes (in theory). You can see on the chart above that in 2006 the Existing Home Sales started to collapsed before the financial crisis. The stock market followed right after.

The general expected Existing Home Sales figure is 4.92M for this morning. Generally, we can assume that the stock market and gold have already priced in this expectation. There are three scenarios possible this morning. The first one is that Existing Home Sales are in line with expectations, in which case we shouldn't see gold or the stock market react after the release of this indicator.

The second scenario is that there's a better reading that expected; let's say something around 5.2M. This would send the signal (in theory again) that the economy is improving. We could expect an outflow from gold to other assets in this case, because of the decrease in fear of investors. This, among other factors, could pump the stock market and make it run higher, for now.

The third scenario is a worst than expected reading; let's say around 4.6M. This could signal an economy that is stagnating or losing steam. This situation would be good for gold as investors would want to hedge against a stock market dip. The stock market, when not disconnected with economic reality, should in theory follow a bad Existing Home Sales reading down.

In reality, a lot of other factors are influencing whether gold and the stock market will go up or down. What I'm personally looking for is the second or third scenario, in which case I could profit from a surprising reading.

Premarket trading plan summary

After the pop of yesterday thanks to the FED, commodities like oil and gold are sinking again this morning. That affects miners like GDX and GDXJ too. The US dollar is up against major currencies and continues to strengthen against assets.

 "Don't take that one day as a preview for the rest of the year though. Investors were largely reacting to language in the Fed statement suggesting that the central bank won't raise rates in April and will likely raise rates only a bit in June or later." - CNN Money 

The market we're in right now is not that complicated: When rates will rise, the stock market will go down. So, as long as the FED keeps this favorable environment alive for stocks, current valuation will stay in place.

My stock COS.CA will get hit today by lower oil price, but I bought it for a swing trade not a day trade. If not, I would have sold it yesterday when it was up 7.5%. I may buy other stocks today, depending on the market's direction. If I do, I will post my transactions here.

Should you fear that the FED hikes rates?

Tomorrow we will see the end of a two days meeting from the FED. Some indicators seems to show strenght from the US economy such as the unemployment rate and total initial claims who both dropped. Will that be enough for the FED to hike rates?

Highly unlikely in my opinion. 

First, we can question the strenght of the economy. The big boys know this and that's why you hear the media still talking about a "recovery" 6 years after the recession. Some signals are more difficult to decode than others, like the ones sent by the bond market.

"The message from the bond market, supposedly, is that the world today is worse than it was than at any point during the Great Recession, which is nonsense," says Paulsen. 

-Yahoo Finance

Is it really nonsense? No one knows for sure, not even Paulsen. No one really knows what's the extent of the benefits and the dommages of the emergency measures the FED used and is still using.

Secondly, we have to think about the consequences of a rates hike. The US dollar would appreciate against other currencies making it more difficult for foreign investors to invest in the US. On top of the loss markets would inccur directly from the currency, investors would start to quickly get out from the stock market. Like Warren Buffet said: "Interest rates are like gravity for the stock market." The real question is not if people would survive another market crash. The real question is whether or not big businesses and the financial system would be able to absorb the shock. I don't think they would.

Finally, analysts are not expecting a rates hike tomorrow, but rather they want to see if Yellen will take out the word "patient" from her speech. If she does, it would mean a rates hike could be close. However, even if she removes that word, I think we won't see a rates hike this year. That being said, tomorrow could be a bloody day for the stock market if Yellen takes that route.

Banks stress test, stock market, and gold

You probably already heard of the Dodd-Frank Act Stress Test that puts 31 big banks through a crisis scenario. They basically test a wide array of scenarios that goes from a small drop in the stock market to a severe collapse of real estate, the stock market, and main street economy.

Such a scenario would include an unemployment rate of 10%; a 25% decline in home prices; a stock market drop of nearly 60% and "a notable rise in market volatility."   USA today

This test is the first half of the big test (the second one is a qualitative test), and the Federal Reserve concluded that it was a success for all 31 banks. 

All 31 U.S. banks passed a 5 percent minimum hurdle for top-tier capital in an annual health check by the Federal Reserve, the central bank said on Thursday, as the industry continues to rebuild buffers after the crisis. Yahoo Finance

You can access the complete test by clicking here.

Should we be surprised of that good result? I don’t think so. If we look at the chart below, we can see that Reserve Balances with Federal Reserve from banks are at an all time high.

In simple terms, after the crisis the Federal Reserve “printed” the money and sent it to reserve accounts. Banks can then expand the currency supply and create more chequebook money through Fractional Reserve Lending.

This newly created money is supposed to flow into main street economy, but the reality is that it has found its way in majority into some assets such as the stock market. Matter of fact, you can take a look at the velocity of M2 Money Stock on the chart below.

This shows that while banks get healthier and the stock market rises, money is not circulating in the real economy. So I’m not really surprised that banks passed the test with a good score. They have plenty of reserves to support a recession.

The stress tests are so named because they measure whether the banks have enough capital to withstand major economic stressors, such as the 2008 collapse of the housing market. A passing grade means they have enough capital to withstand, say, rising levels of unemployment or plunging commodity prices. - USA Today

Now, the real question that we can ask ourselves is if regular people would pass a stress test. Let’s take a look to Real Median Income to answer the question.

Since the crisis regular people earn less money. But at the same time it looks like they understand the importance of saving money since the crisis as you can see on the chart below.

However, I don’t think the majority of people would pass a stress test. If there was a major crisis, the system and banks would be ok for a certain period of time, but I think regular people would suffer.

Another interesting point is the correlation between Reserves Balances and the S&P500 as you can see on the first chart of this article. It basically shows that if the S&P500 would crash by 60%, banks have a big enough cushion. It also shows that when they’ll start pulling out the money from the stock market there will be a danger for inflation if they inject it in the real economy.

At that step, we may see a rush into gold to protect wealth. But before that turning point, I doubt gold will be traded at August 2012 levels. However, I believe gold will remain of strong value in the meantime.

In conclusion, I don’t think a crisis would crash the whole system and banks like some people say. However, I think it will be a much greater threat to regular people who could see their wealth be wiped out if they don’t protect it.