Palomar Capital

  • Should Investors Sell in May and Go Away?

    US stocks finished their biggest monthly rally this April since 1987. The market rose 12.7% over the month, cutting the coronavirus-driven losses on the S&P 500 to about 10 per cent year to date, despite an economic shock far greater than the financial crisis a decade ago.

    Some investors have expressed doubts about whether the rallies have further to run but are reluctant to bet against the massive interventions by central banks and governments around the world.

    The rally in equities is not driven by fundamentals but by the liquidity support from the Federal Reserve.

    The rally has been led by the tech sector that dominate the US stock market. Amazon and Netflix have both gained more than 40 per cent from their mid-March lows, benefiting from the shutdowns around the world that have kept billions of people indoors, reliant on home delivery and streaming entertainment.

    A big gap between signals from the commodities and bond markets, which indicate expectations for a long period of low growth and stocks, which are pricing in a strong rebound for economic growth and corporate earnings. It is a tug of war between central bank policy and stock fundamentals. Right now, policy is winning.

    Howard Marks of Oaktree recently said on CNBC “We’re only down 15% from the all-time high of February 19, and it seems to me the world is more than 15% screwed up.

    “It took seven years to get back to the 2000 highs in 2007,” Marks told CNBC. “It took five-and-a-half years to get back to the 2007 highs in late 2012.”

    “Is it really appropriate that, given all the bad news in the world today, we should get back to the highs in only three months? That seems inappropriately positive,” he added.

    So, does the Halloween Indicator actually work?

    Looking at S&P500 monthly returns from 1928 to present we can see that November — April Returns are on average 5.1% while May — October returns average out at 2.1%

    An academic paper by Jacobsen and Bouman from 1998, which was updated in 2009 finds that this inherited wisdom is true in 36 of the 37 developed and emerging markets that they studied. The ‘Sell in May’ effect tends to be particularly strong in European countries and is robust over time. Sample evidence, for instance, shows that in the UK the effect has been noticeable since 1694.

    So, what is the lesson of this? Should investors follow every investing adage that they hear? No, hopefully your take-away from this piece is that most ideas that are testable should be tested. It took less than fifteen minutes for me to download the monthly data and study this effect. While returns are indeed lower over the summer half of the year, there is a general positive expectation associated with investing in stocks. If you want to have a handful of winning investment rules, the best way to get them is to download some stock market data from the internet and test your ideas.


  • How Can The Price of Oil Go Negative?

    The oil price turned negative for the first time in history on Monday. A strange as this seems it is driven by limited storage capacity and technicalities in how oil is traded. You should not expect the gas stations to pay you to fill up your car quite yet.

    When an investor buys a stake in a company they can hold on and wait for the price to go up. Oil doesn’t work that way.

    If an investor wants to buy oil and profit from its rise in price, they need to have a way of storing it.

    For this reason investors don’t usually buy physical oil, they buy, a financialized version of oil using a derivative known as a futures contract that rises and falls with the price of oil. Futures are legal contracts to buy or sell a particular asset at an agreed upon price at a specified time in the future.

    The problem for investors is that futures contracts have an expiration date when the investor must take delivery of the physical oil.

    Financialized oil today converts into real oil in when the contract expires. Investors often never wish to take delivery of physical oil. They aim to sell the futures contract before it expires, take their profit or loss and move on without ever dealing with physical oil.

    If an investor at the end of May wishes to continue their bet on the price of oil, having bought the May futures contract, they sell those futures and buy the June futures to replace their position. This is known in the industry as “rolling” the futures. As the June expiration approaches, the investor can repeat. They keep their position in financialized oil without the inconvenience of dealing with physical oil.

    An oil ETF (exchange traded fund) appears to give investors permanent financial exposure to financialized oil, but the ETF administrator typically doesn’t own an oil storage facility. They create an ETF by buying futures and rolling them.

    In the end someone must store the physical oil represented by these financial instruments. If oil prices are in contango meaning the next to expire contract is cheaper than the contract expiring a month later, by rolling the futures you are essentially paying someone else to store the oil for a month.

    An investor could right now buy the May contract and sell the June contract, take delivery of the oil in May, store it for a month and deliver it in June making a profit on the storage. The problem is that they would need access to a storage facility where they could keep this oil for a month.

    Oil has not actually taken on a negative value. Oil has a value and investors want to speculate using financial instruments, on its future prices but demand is very low for physical oil right now as the global lockdown has reduced demand and there is limited storage space in the United States.

    Mondays selloff left WTI Crude at its lowest level since record keeping began in March 1983. June prices also fell, but were trading above $20 per barrel. Brent Crude — the benchmark used by Europe, was also weaker, down 8.9% at less than $26 a barrel.

    In economics, products do not ordinarily have negative prices. If nobody wants a good or service, production just stops. But it is not so easy to stop and then restart an oil well.

    The price of the oil contract expiring on Tuesday April 21 has not fallen to a negative price because nobody needs or wants oil. Futures prices show us that there is demand for oil. But today, with the world in lockdown, people need less oil right away and due to limited storage space it is difficult to come up with a reasonable price for oil for immediate delivery.

    To better understand how this works watch this quick explainer I posted on YouTube the day before expiration to explain what was going on.