Bear Markets Are About Price AND Time.

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Without doubt, the biggest event in 2015 (economically speaking) was the collapse in the oil price. And it’s still going on. From Reuters:

Brent crude oil prices hit their lowest in more than 11 years on Monday, while U.S. crude flirted with seven-year lows on more signs that swelling global supply looked set to outpace tepid demand again next year.

Global oil production is running close to record highs and, with more barrels poised to enter the market from nations such as Iran and Libya, the price of crude is set for its largest monthly percentage decline in seven years.

Oil can’t take a trick right now. Everything is coming together to push the price lower. Saudi Arabia is churning the stuff out in the hope of knocking out high cost producers. The high cost producers’ response is to produce more of the stuff at a lower cost.

Meanwhile, Iraq, Iran and Libya are now adding to global supply. And to top it all off, the US is experiencing an unusually warm start to winter, so demand is lacklustre.

Let’s have a look at a chart of Brent crude…

Source: StockCharts

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This is what a bear market looks like on the charts. In late 2014 you had a ‘waterfall decline’. Brent bottomed just under US$50 a barrel. At this point many people thought it was THE bottom. And for the first half of the year they were right.

But the rally was simply an attempt to restore a bit of balance to the market. A good way to work out the difference between a deceptive bear market rally and a genuine change in trend is to keep an eye on the moving averages.

You can see these in the chart above. They are the red and blue lines. Moving averages smooth out volatile daily price moves. They give you a better idea of the underlying trend.

Using the moving averages as a guide, you would have avoided being caught out by the bear market rally during the first half of 2015. As you can see they never crossed over to the upside, which would have been the first sign of a change in trend.

Instead, the price of Brent turned back down. The moving averages then resumed their downward trend.

Over the past month, the Brent crude price has fallen sharply. It broke below the August low and is now trading around US$36.50 a barrel, the lowest point in 11 years.

So where to from here?

Well, in the short term, Brent is overly stretched to the downside. You can see this by looking at how far the price is from the moving averages. While the moving averages follow price, they also act as a magnet. If the price falls too far, too quickly, you usually see a bounce back towards the moving averages.

There’s a good chance you’ll see such a rally get underway in the next couple of weeks. Supporting this view is the fact that since peaking in May at around US$68 a barrel, Brent crude has now declined nearly 50%.

That’s a large decline. Following falls of this magnitude, you often see a rally get underway. On this assumption, you might see oil kick 2016 off with a rally. But it has a long way to go before you can confidently say a change in trend is underway.

For that, you want to see the price head back above the moving averages. Then you want to see the moving averages cross over to the upside and start heading higher. This will tell you the bear market is probably over.

For subscribers of Crisis & Opportunity, this is what I’ll be looking for in 2016. The energy sector has been one of the worst performers over the past few years. It’s going through a genuine crisis. But that’s where the opportunity lies. The trick is to not rush in too quickly and buy during the downtrend.

Energy is a capital intensive business. When prices are as low as they are now, some large projects barely cover their cost. Returns on capital decline and the share price does too.

But as night follows day, this situation will reverse. My best guess is that oil and energy related stocks will be standout buys in 2016, probably in the second half of the year.

Time will tell, but it’s a sector I’m keeping a close eye on.

I’m also watching gold closely. Like oil, gold in US dollar terms is still in a bear market. Take a look at the chart below…

Source: StockCharts

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This gold bear market has been going on for years. Gold peaked in September 2011, so it’s been over four years now of prices heading south.

As I’ve pointed out on many occasions over the course of this year, the situation is a little different for Aussie dollar investors. But for now, let’s just focus on the US dollar price.

As you can see in the chart, gold recently made new lows and the moving averages continue to trend lower. It’s classic bear market stuff. Gold needs to break above the October high before you can get excited about the end of the bear market. That’s about US$100 an ounce higher than where it is now.

Unfortunately, the odds favour the bear market grinding on. While oil has more than halved from its peak, gold still hasn’t hit its 50% loss threshold.

Bear markets are about price AND time. Oil fell hard and fast. Gold fell soft and slow. It will be interesting to see if they both bottom around the same time in 2016. I’ve already got one stock pick waiting in the wings to benefit from the precious metals turnaround.

It’s shaping up to be another fascinating year.

Regards,

Greg Canavan,

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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