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Bull market pointers

Bull market pointers
October 8, 2015
Bull market pointers

For instance, the ICE one month forward Brent Crude contract has risen by 25 per cent since hitting a six-year low of $42.23 on 24 August 2015, potentially a significant development given that this price level also represents a retest of the oil price lows in mid-February 2009. I don’t need to tell you what happened after that as, within a matter of weeks, equity market bears turned to bulls, a major turning point that marked the start of the ongoing bull market.

There are fundamental reasons for the rise in black gold too as the International Energy Agency (IEA) recently upgraded its global demand estimate for 2015, reflecting raised forecasts for price-sensitive US demand in the second half this year. There has also been a rebalancing of supply-demand as OPEC production in August was down 220,000 barrels of oil equivalent per day (boepd) at 31.5m, or just under a third of global supply, with declines seen in Angola (90,000 boepd on maintenance), Iraq (90,000 boepd on pipeline outage) and Saudi (100,000 boepd on export phasing).

Of course, investors are forward looking and will have noted that 2016 supply growth is now expected to slow materially as lower prices continue to drive capital expenditure cuts in the non-OPEC world. To put this into some perspective, energy consultancy Wood Mackenzie estimates that capex budgets have been slashed by US$145bn (£95bn) in 2015, with a further US$200bn (equivalent to 20bn boe) of investment deferred until prices recover.

In the near term the burden of this cut in supply is expected to fall on the US independents: the IEA's second successive cut to 2016 supply growth (270,000 boepd last month, representing a near 500,000 boepd year-on-year decline) is almost entirely being driven by the US. It’s being seen on the ground too as US rig counts have now fallen for five consecutive weeks, a leading indicator of a future decline in production.

A continuation of the rebalancing of supply and demand is much needed as OECD inventories stand at 2,923m barrels, or 200m barrels above the five-year average. That’s the equivalent of 63 days of global demand, well above the 10-year range, and storage levels are at record highs in a number of regions: US crude storage stands at 85 per cent of working capacity, up from 60 per cent at the end of February. But with global demand expected to pick up by between 1.3m to 1.4 boepd in 2016 - according to the latest forecasts from OPEC, IEA and the US Energy Information Administration (EIA) - and reflecting the market dynamics of lower oil prices on stimulating demand, then we are getting far nearer to an equilibrium being formed in the market.

Indeed, with global oil demand growing at its fastest rate for five years (3.3 per cent year-on-year), this means that the oversupply in the market will start to be eroded sharply from the second half of 2016 onwards, according to analysts at investment bank UBS, assuming of course stable OPEC production. But that’s without factoring in the possibility of an escalation of instability in the Middle East leading to key production hubs being taken off stream and having a prolonged impact on the oil price. It’s a massive call to make, but the summer lows in the oil price could in hindsight prove to be a major turning point both for the oil market and the equity market too.

Equity market watch

That’s relevant to stock market investors who had become obsessed with the economic slowdown in China, albeit there has been little in the way of a softening in demand for oil there in the first half of this year as Chinese demand is up 7 per cent in the 12 months to end-July with lagging industrial use more than offset by growth in gasoline and kerosene demand. Moreover, the pull back in stock market valuations has largely been down to a higher perceived risk of a global ecomomic slump, something that's completely at odds with sharply rising demand for oil.

I have already outlined the implications of the Chinese economic slowdown on western economies in two lengthy macroeconomic articles (‘A sense of perspective’, 1 September 2015 and ‘Stay calm’, 25 August 2015). I took the view then, and still do for that matter, that the equity market sell-off is overdone and represents a buying opportunity.

Bearing this in mind I strongly feel that a higher oil price is far more relevant to improving investor sentiment, and driving higher equity market valuations, as this will only happen as supply realigns with growing demand. And that demand growth will indicate that the risk of a major global economic slowdown, embedded in current equity market valuations, has been overplayed. Indeed, the fall in the oil price has been closely correlated with cyclical stock underperformance and a fall in inflation expectations, so offering scope for equity outperformance if global economic growth is better than expected. Analysts at investment bank Morgan Stanley are clearly bullish, issuing a buy call yesterday on emerging markets and commodities, predicated in part on improving newsflow emerging from China in the fourth quarter.

They are not the only one thinking this way as the leader board of the commodity heavy FTSE 100 index over the past week tells a story: share prices of oil majors BP (BP.: 378p) and Royal Dutch Shell (RDSB: 1776p) have both racked up gains of around 15 per cent from their end September lows, and have been a key driver in the recovery in the blue chip index. These price moves are being mirrored in the US with the likes of oil giants ConocoPhillips (COP: NYQ - $55.14) and Chevron (NVX: NYQ - $86.99) putting in double digit share price gains in the same period.

Of course, stock market bears will contend that the recent reversal of the summer losses is just a sharp bounce back rally, rather than the end of a correction phase in the ongoing bull market. However, I feel that this rally has legs and I am not changing my view that the equity market sell-off we witnessed this summer represented no more than a correction within the ongoing bull market rather than signalling a major market top is in place. I also note that equity market volatility has been unwinding with the VIX index, Wall Street's gauge of fear, falling to a reading well below 20 from a high of 52.5 at the end of August. This is positive for a continuation of the rally in equities, albeit expect whipsaw movements as investors try to regain their composure and trust the recovery.

Positive back drop

On fundamentals they should because the combination of the lagged economic boost from the slide in the oil price in the past 12 months, the ultra low interest rate environment providing cheap borrowing for consumers and corporates alike, and a push back of the start date for the rate tightening cycles in both the US and UK, is conducive to a favourable backdrop for equities in the historically benign fourth and first quarters.

Moreover, as we near the year-end, investor focus switches from what has occurred this year to what prospects are likely for 2016. On this count, consensus points to European equities delivering high single digit earnings growth next year. Net earnings of the Dow Jones Eurostoxx 600 index are predicted to grow by 9 per cent in 2016 which means that the index is currently rated on 14.3 times forward earnings and offers a forward dividend yield of 3.8 per cent. The FTSE 100 is rated on 14.7 times fiscal 2016 EPS estimates and offers a prospective dividend yield of 4.3 per cent. Although by no means bargain ratings, in the context of 10-year bond yields of 0.6 per cent in Germany, 1.84 per cent in the UK and 2.07 per cent in the US, earnings yields of 6.5 per cent or higher are attractive in a low inflation, low interest rate environment.

The push back in the likely date of the first interest rate move by the Federal Reserve is also supportive of equities, a point I made in my September equity market strategy column (A sense of perspective’, 1 September 2015) when I forecast the US central bank would delay the date of its first long awaited interest rate hike. This scenario is panning out. Following last Friday’s US labour market data, odds favour March 2016 as being the most likely start of the US tightening cycle with the probability of a rate rise at the Federal Open Market Committee (FOMC) meeting on October 27/28 now only 5 per cent, and at the December 15/16 meeting only 27 per cent, down from 60 per cent three months ago.

And although the price of Brent Crude has rallied by a quarter in the past few weeks, it’s still worth remembering that the price is down by a 55 per cent since the end of June 2014. That’s significant because analysis by the European Central Bank (ECB) shows that every 10 per cent decline in the price of black gold boosts the region's GDP by 0.08 per cent in the first year, a cumulative 0.19 per cent in the second, and 0.24 per cent in the third year, so there is still a sizeable economic boost yet to come through in Europe, the major trading partner of the UK.

Relatively cheap fuel is obviously supportive of the US recovery: the economy came within a whisker of notching up an eye-catching 4 per cent GDP growth rate in the last quarter. The UK, as a net oil importer, is another beneficiary of what is tantamount to a massive tax cut for consumers. Add to that a favourable domestic back drop underpinned by low inflation, a recovering housing market since the general election, and rising nominal and real earnings growth, and I am relatively optimistic on the near-term domestic economic outlook in the UK.

I am not the only one taking this view as the FTSE SmallCap index has hauled back almost half the losses since bottoming out in late August and is less than 5 per cent off its June all-time high. In the circumstances, I remain on the look-out for niche buying opportunities in my specilalist small cap hunting ground to capitalise on likely positive momentum in share prices as risk appetite improves during the seasonally benign fourth quarter. I highlighted the investment opportunity in the shares of property company LXB Retail Properties (LXB: 88p) earlier this week ('Bag a retail property bargain', 5 October 2015), and intend initiating coverage on another small cap in my 12pm article on Monday, 12 October 2015.

Please note that I have written articles on 10 small cap companies this week, all of which are detailed in chronological order in the list below.

MORE FROM SIMON THOMPSON...

I have published articles on the following companies in the past fortnight:

Trakm8: Run profits at 195p, target 220p; Character Group: Run profits at 518p, target 575p; Marwyn Value Investors: Buy at 220p; Global Energy Development: Speculative buy at 30p; Software Radio Technology: Buy at 27p, target range 40p to 43p; Globo: Buy at 33p, target 69p; Pittards: Hold at 105p ('Cashed up for cash returns, 22 Sep 2015).

KBC Advanced Technologies: Buy at 112p, initial target 142p; K3 Business Technology: Run profits at 298p; Cenkos Securities: Buy at 177p; Netplay TV: Buy at 10p ('Small cap value plays', 23 Sep 2015).

Miton: Buy at 26.5p, target 35p; 32Red: Buy at 73.75p, target 90p; Stanley Gibbons: Buy at 138p; Vislink: Buy at 40p, target 70p ('Building momentum', 29 Sep 2015)

Moss Bros: Buy at 97p, target 120p; GLI Finance: Buy at 52p, target 80p; Town Centre Securities: Buy at 315p, target 350p; Globo: Buy at 39p, target 69p (‘Platforms for success’, 30 September 2015)

Safestyle: Run profits at 255p; Epwin: Run profits at 138p; Manx Telecom: Buy at 188p, target 210p (‘Income plays with capital upside’, 1 October 2015)

LXB Retail Properties: Buy at 86p, target 99p ('Bag a retail property bargain', 5 October 2015)

Creston: Run profits at 162p, target 171p; Fairpoint: Run profits at 184p, new target range 200p to 220p; Trifast: Buy at 114p, target 140p; 600 Group: Buy at 16p, target 24p; Renew Holdings: Buy at 315p, target range 350p to 375p; Stanley Gibbons: Hold at 105p ('Engineering ratings upgrades', 6 October 2015)

STM Group: Buy at 71p, target 80p ('Riding small cap winners', 7 October 2015)

First Property Group: Buy at 39.5p, target 49p ('In pole position for re-rating', 7 October 2015)

Tristel: Run profits at 99p, target 110p ('Cleaning up with superbug buster', 7 October 2015)

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'