Assessing the factors behind volatile markets

Watching the markets melt down with the combination of coronavirus and the Russia-Saudi Arabia oil war is providing front row seats to bear market dynamics.

For the stock markets, I suspect it’s a medium-term bear market, partly a correction in response to excessive gains last year in an already tired bull market, and now pushed into a recessionary slump by COVID-19.

I’m guessing that in a year or two, the next long equity bull market will begin, after this mess is cleared out.

For oil and other commodities, I’m sure it’s just another savaging by the long-term bear that’s running around for the foreseeable future.

In the post-2014 environment, commodity prices can rally quite a lot in percentage terms, but they’re trapped beneath a ceiling created by too much capacity and the ability of many to crank up production every time prices rise.

That’s also why there’s no real downside limit in commodity prices today. As with the Russia-Saudi situation today, if somebody gets aggressive or grumpy, they can put the hammer down on production and flood the market.

While this oil war might look like a battle between two major exporters, underneath it all is a bigger strategic target for both the Russians and Saudis — the U.S. shale oil industry.

Oil prices have been suppressed by the massive, truly incredible and historical development of the U.S. as not only self-sufficient in oil, but even an exporter. That is annoying the heck out of the traditional exporters and oil-reliant powers like Russia and Saudi Arabia.

But shale oil is costly and today’s prices have fallen far beneath what most U.S. producers need to break even. The motors for some of the over-leveraged U.S. players will start blowing. Drilling and exploration will be curtailed. Loans will be called and production will fall.

That’s what will eventually end this war. Enough U.S. production, and that of other high-cost producers (some Canadian oilsands production?) will be killed, demand will begin to drive up prices, and the old faithfuls of the oil exporting world will once more be collecting what they consider acceptable profits.

It isn’t so easy for any major player to instantly flood the markets with crops and other agricultural commodities. There are no dominant players, just millions of individual farmers. (China’s import and export authorities are arguably one exception to this reality, able to restrict or flood through their stockpiles and import controls.)

But weather can do to ag markets what the Russians and Saudis are doing to the oil market. We’ve had quite a year of bad weather conditions around the world, affecting much of North America, Australia and Europe. Yet, we have lots of crops keeping a lid on prices.

Imagine if we get good weather everywhere this year, next year, or any time soon.

If you accept that we’re living in a long-term commodity bear market, this oil price war is a good reminder that hedging against the downside is always important. There are definitely counter trend rallies during bear markets, but they tend to be brief and evaporate once a temporary supply constriction has disappeared.

Downside shocks can be more profound, and more long-lasting. They can be severe, like the one in oil today.

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