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Market Outlook

Neither the Bull Nor the Year Is Over, Yet

By Elliott H. Gue, on Dec. 4, 2017

The S&P 500 logged its first-ever close above 2,600 the other week, and history suggests that the bias remains to the upside through year-end: The index has rallied from mid-November to the end of the fourth quarter in almost 83 percent of the past 67 years.

On only five occasions over this period has the S&P 500 given up more than 2 percent of its value in the final month and a half of the year, with most of these instances occurring during broader bear markets.

We’re not inclined to fight that seasonal record.

Looking ahead to 2018, 65 weeks have passed since the S&P 500 last endured a correction of 2 percent or more—the longest stretch since the mid-1960s. We’d be surprised if stocks don’t break this historic winning streak at some point in the first quarter of 2018.

However, the conditions that historically drive bear markets aren’t in place, suggesting that US equities could have more headroom in 2018.

History shows that the S&P 500 rarely tops out more than 12 months before a recession, but the US economy appears to be strengthening. The Federal Reserve Bank of Atlanta’s GDPNow model estimates the fourth-quarter growth rate at 3.4 percent, and the New York’s Fed’s Nowcast projects a 3.7 percent expansion.

These models, both of which reflect quarter-to-date economic data, track well above consensus expectations for US gross domestic product (GDP) to increase by 2.7 percent in the fourth quarter and 2.2 percent in the first quarter. This divergence between incoming economic data and Wall Street’s consensus estimate suggests that upward revisions could be in the cards.

From a technical standpoint, narrowing market leadership historically has provided an early warning that a bull market could be winding down.

The market has suffered a few breadth-related scares over the past two years; however, the NYSE Advance-Decline Line broke to an all-time high last week, indicating that market leadership has widened. Short-term pullbacks and corrections aside, more upside appears to be in store for US equities.

Our outlook calls for market leadership to shift in 2018. Information-technology stocks account for about 25 percent of the S&P 500, the sector’s highest weighting since the 1999-2000 tech bubble. Financials and energy stocks—sectors that fall into the value category—appear well-positioned to lead the bull market in 2018. Since many institutional investors rebalance their portfolios near the start of a new quarter, the passing of the baton often occurs early in the new year.

Crude Oil

We maintain a bullish bias for oil prices into 2018.

Amid the welter of OPEC-related news, forecasts for global supply and demand, and price outlooks for 2018, we prefer to focus on what the market tells us: Crude oil is in the early innings of a cyclical recovery.

Brent crude oil remains in backwardation, with front-month futures trading at a premium of $2.89 per barrel to volumes slated for delivery 12 months later. This structure discourages market participants from storing oil—why pay for storage to receive a lower price down the line—and indicates a tightening supply-demand balance.

Although oil prices have rallied on several occasions over the past three years, longer-dated Brent futures prices still commanded a premium to near-term contracts (contango).

Regardless of what OPEC, the International Energy Agency and the Energy Information Administration project for 2018, the futures market tells us that the global supply-demand balance has tightened heading into 2018.

Monthly pricing data indicate that the Brent futures curve has flipped from contango to backwardation five times since 1998: March 1999, February 2002, July 2007, February 2011 and September 2017. Excluding the most recent instance, front-month Brent oil futures rallied by an average of 41.7 percent in the 12 months after these shifts occurred.

This data set includes a 62.5 percent rally that started in March 1999 and a 10.2 percent pullback that began in February 2011; the latter retrenchment occurred after oil prices hovered around historical highs of more than $100 per barrel through mid-2011.

Our forward outlook leans against the consensus forecast once again. Although we concur that rising US production presents a risk to oil prices, much has changes since November 2016.

The US oil-directed rig count soared 50 percent in the months leading up to OPEC’s fall 2016 meeting, driving a rapid increase in domestic oil production in early 2017. Fast-forward to today when the US oil-directed rig count has increased by less than 5 percent since the end of May 2017 and has declined from its summer high.

Although efficiency gains allow producers to drill more wells with per rig, we’re not going too far out on a limb when we assume that a flat US rig count will translate into a slower rate of production growth than when the number of active drilling units increased by 50 percent over six months.

Break-even prices for US oil production are more likely to rise going forward than to continue the downtrend of the past few years. Declining production costs have stemmed from a combination of secular factors, such as improved well designs and fracturing techniques, and cyclical factors, such as price concessions from service companies to win business in a bear-market for oil.

However, cyclical factors are likely to bolster service costs at a pace that will offset incremental efficiency gains. Consider these comments from Halliburton’s (NYSE: HAL) management team on the market for completions-related services during the company’s third-quarter earnings call:

The North America completions market remains tight, and we continue to push pricing across our portfolio every day. Demand for our completions equipment and service quality remains strong. The improving oil price outlook provides runway for us to increase our portfolio pricing as we go forward.

So, let me be clear. We still have the ability to push price. Equipment utilization comes in a couple of forms. First, it has to be working, and second, it has to be working for the right customers. Our fleet is sold out for the remainder of the year and into 2018. We continue to place our equipment with those customers who know how to effectively and efficiently use us to increase their productivity, which improves our utilization.

Some US shale players also highlighted signs of tightness in the pressure-pumping market, including delays in well completions and difficulties securing fracturing crews. Although the magnitude of pricing gains will be uneven across different service and product categories, industry costs tend to be pro-cyclical—that is, higher commodity prices tend to translate into higher expenses for producers.

Moreover, the market’s focus has shifted from rewarding production growth at any cost to a preference for return on investment. In this world, upstream operators that can fund their development programs and drive production growth internally while generating real cash flow will have an edge. This newfound discipline may reduce producers’ willingness to reactivate rigs in response to short-term rallies in commodity prices.

Although we remain bullish on oil prices for next year, the potential for a near-term pullback remains a concern, as hedge funds have accumulated a near-record long position in Brent (526 million barrels from a low of 200 million in June) and WTI (344 million barrels from a summer low of 134 million) futures.

Our outlook for 2018 calls for WTI to average between $55 and $60 per barrel, while spending the bulk of its time between $50 per barrel on the downside and $65 on the upside.

Capitalist Times Premium subscribers already receive trade ideas and model portfolios based on our market outlooks. If you aren’t a subscriber, become one now! We’ll be issuing our annual review and comprehensive 2018 outlook soon!

Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

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