Deja Vu All Over Again

In my post at the start of last week I was looking at the escalating economic shock that is the closure of the Strait of Hormuz, but also noting that the lack of patterns on equity indices from the late March lows were nonetheless looking higher.

US equity indices haven’t gone up a lot since then, with the exception of an impressive performance on QQQ, but I’m still thinking that SPX and QQQ in particular may go higher still and have some trendline targets to put forward in the event that turns out to be the case.

First though I’d like to look quickly at the current status of the Iran War and then take you on a walk down memory lane looking at the weeks before the last really big crisis in equities, which was of course the early weeks of the pandemic in 2020.

On Iran I wrote a post last Thursday on my The Bigger Picture substack looking at why the Iran War was largely irrelevant in the context of the economic shock being created by the closure of the Strait of Hormuz. If you haven’t already read that I’d suggest that you do that.

Further to that post there are two important dates coming up. The first is at the start of May, when the US Constitution requires the administration to go to Congress to authorise this war. That may or may not happen of course and the US administration may just argue that the war was never really a war and is in any case already over, but in the event that they don’t receive that authorisation the war needs to be wrapped up within the following thirty days.

I don’t know how seriously this administration will take this constitutional obligation but at the least this suggests that any active hostilities and the current embargo may be over by the end of May.

The second date is more important and is the consensus view I’ve been reading that the released strategic reserves and all the oil in transit after the closure of the Strait of Hormuz are likely to be exhausted by May 10th. That could be delayed a bit further, perhaps by the release of more strategic reserves, but as and when any surpluses have been used up, we will start a process of price discovery / demand destruction on oil.

The shortfall of the reduced supply vs demand looks to be in the region of ten million barrels per day or more. There is a decent analysis of how that is comprised here if you are interested. In the absence of other sources the price of oil will need to rise until it reaches a level where that ten million barrels per day shortfall is eliminated by demand destruction, because those ten million barrels per day are no longer wanted at that much higher price.

In that process I think we would likely see oil prices reach new all time highs in the $150 area, and may well see then reach new all time highs adjusted for inflation, which for Brent and West Texas Intermediate Crude would be in the $225 area. This would be a major worldwide economic shock, and as you can see looking at the chart below would likely put much of the world, including the US, into recession.

The best comparisons for this oil shock would likely be the mid-1970s and 1990 oil shocks:

So to summarise, we are looking at a major economic shock to the world, starting in a couple of weeks or so, that will likely happen to a significant degree even if the Strait of Hormuz were to be fully opened to commercial shipping today, as it takes a while for oil tankers to reach their destinations even when they can pass freely.

So why are equity indices still rising? Well let’s have a look at the last major shock to the world economy in 2020. The COVID shock was predictable. I remember talking to my brother in late January 2020 discussing the WHO not imposing flight controls and speculating as to whether that was because it was already too late to stop the coming pandemic. Many people saw the problem coming. Analysts were cautious about predicting a problem that people didn’t want to see, and markets hoped it would all just go away until it became undeniable that it wouldn’t.

I wrote a post on 19th February about the nascent pandemic and talking about the risks to world markets, and one thing I was watching but didn’t mention was that by the time I wrote that post there had already for several days been growing shortages of toilet paper in shops across the world including the US. That toilet paper shortage was created by people who could see what was coming and were hoarding essential supplies.

Those hoarders were all ahead of equity markets, which rose 5.5% from the start of February 2020 into a new all time high on 19th February, at which point reality finally started to bite and equities started to fall.

I wrote another post on 24th February looking at the start of the decline from the high, and SPX went on to decline 35.4% over the next month into the crash low at 2191.86 on 24th March 2020.

Where SPX topped out in February was interesting however, with the move up in February hitting a high quality resistance trendline for the rising wedge from the late 2018 low. This entire wedge would then be fully retraced over the following month.

SPX daily chart from 24th February 2020:

The question is whether we might see a similar move here. We still have a couple of weeks before reality becomes really hard to ignore and I do have a couple of high quality trendlines that might be hit in that time.

On SPX I have a decent looking rising megaphone from the late 2022 low, and at the time of writing I have the resistance trendline in the 7360 area.

SPX weekly chart:

On QQQ I also have a decent looking rising megaphone from the late 2022 low, and at the time of writing I have the resistance trendline in the 680 area.

QQQ weekly chart:

These trendlines don’t need to be hit, and rationally they really shouldn’t be hit, but I’ll be watching these, and if reached, they should both be a solid sell there in my view.

I’ll be doing a post later this week with a shorter term view, but I was having a careful look at equity indices over the weekend, and wanted to share these as possible upside targets.

In the meantime we are in the early stages of a major economic shock to the world that may well be comparable to the pandemic in 2020, and when we make the high for the current move, I’m thinking that high may last the rest of this year and perhaps next year as well. Be careful out there.

If you like my analysis and would like to see more, please take a free subscription at my chartingthemarkets substack, where I publish these posts first. I also do a premarket video every day on equity indices, bonds, currencies, energies, precious commodities and other commodities at 8.45am EST, but only for paying subscribers. Other places to find me are my page on the platform previously known as twitter, and my YouTube channel.

 

So Far, So Good in The Strait of Hormuz

I’ve written well over two thousand posts over the last sixteen years, and this will be the first that doesn’t include any charts that I drew myself. That feels a bit strange but I’m writing this post to draw everyone’s attention to what is really important about this Iran War.

The war itself is largely irrelevant. Whether the US, Israel or Iran are bombing, or blockading, or blustering doesn’t really matter. All that is really important on the bigger picture are the Strait of Hormuz and, to a slightly lesser extent, the Bab al-Mandab Strait, the two key chokepoints for world trade routes in the Middle East:

What is important here is that the amount of tankers and trade volume through these Straits, and that traffic through the Strait of Hormuz dropped over 90% at the start of this war and has on average remained at or below that level since then.

To put that in perspective the last oil tanker that passed through the Strait of Hormuz before this war started delivered that cargo on Monday 20th April. After the war started there was a grace period while the tankers still on the sea delivered their cargoes. That grace period has now ended and the Strait is still closed.

There are still oil reserves that have been released to work through, but once they are used up this supply shock will be fully on, and prices will rise to destroy demand until supply and demand for oil balance again. That is what an oil shock is really about.

There are two previous oil supply shocks historically to compare this crisis with, the first in the 1970s and the second when Iraq invaded Kuwait in 1990. In terms of the percentage of world oil supply disrupted both were smaller, and this disruption is already close to lasting longer than in 1990 and may yet last longer than the five months in 1973.

The summary below looks at what happened in these two previous supply shocks to oil prices, equity valuations, GDP and inflation and it is grim reading:

It isn’t just about oil of course, 30% of helium worldwide comes from Qatar and and much of that capacity has been damaged in this war and will be offline for years. That capacity is not obviously even possible to replace, as it is produced as a byproduct of Natural Gas, and prices have already risen over 50% in the demand destruction cycle to balance supply and demand. Helium is vital to semiconductor manufacturing among other uses.

Other major disruptions include aluminium and urea, which is very important for fertilisers. The chart below is Urea prices from the start of 2022, rising rapidly back towards the 2022 highs. This will restrict world food production and deliver higher food prices that will feed though (no pun intended) over the next few months:

In terms of the impact on equity prices, the milder outcome was in 1990 when stocks were slightly overvalued and stocks dropped 21% peak to trough. In 1973 stocks were somewhat more overvalued and markets dropped 52% peak to trough over the next two years, only recovering to the previous highs after seven years.

So are stocks overvalued now? Well the chart below is the Schiller P/E ratio since 1870. The current level is 20% higher than the high in 1929, and about 10% lower than the all time high in 2000. For comparison the Schiller P/E ratio was at about 18 in 1973, and 17 in 1990 against a historical mean (before 1990) in the 14% to 15% area. It is currently over 40. There is a strong argument that stocks are extremely overvalued here.

How fragile is the market? Are market expectations diverging from the real economy? The chart below is a look at the S&P and Consumer Sentiment since the start of 2007. It is a thought-provoking chart:

The bottom line here is that all that really matters here is the supply shock to the world from this war in the Middle East. Nothing else is of global importance. Until commerce is flowing freely through these Straits, whether or not Iran is charging a toll, the world is exposed to a severe economic shock , stagnation and inflation. The US is a large oil exporter and is more insulated from this crisis than many, but is a long long long way from immune.

Once this supply shock ends we can see how bad this shock is likely to be as the effects feed through over the next few months and years. So far the speed of international trade has insulated the world from this supply shock but that won’t be the case going forward.

We have yet to see the real effects of this Iran War, and it is important to remember that the news about the war that we see every day is mostly just noise, of no real importance on the bigger picture here.

Overall this situation reminds me of a joke my father used to tell. A man jumps off the top of the Empire State Building and halfway down the building is heard to say ‘so far, so good’. It isn’t the fall that kills you, it’s the landing. That is the thing to focus on.

If you like my analysis and would like to see more, please take a free subscription at my thebiggerpicture substack, where I publish these posts first and for members (from next week) also bi-weekly videos looking at equity indices, bonds, currencies and commodities. Those videos are posted on my Youtube channel after a seven day delay. Links to all my posts from my charting substacks are also always posted on my twitter.