Specious Argument

The Wall Street Journal featured a helpful article “Happy New Year…Now What?,” (subscription required) that stated:

Collectively, Wall Street forecasts are similarly inconsistent. Since 2000, the S&P 500 has returned a 4% average annual gain, excluding dividends. By comparison, Wall Street strategists have predicted 10% yearly returns, according to Birinyi. And, on average, the consensus always has predicted annual gains, missing all five down years in that stretch.

So what’s my take? My take is that Wall Street strategist forecasts are essentially useless.

Going into 2015, I wrote that SPX options had a skew to the downside, implying that there was more downside risk. Using a similar process, let’s look at SPX options for 2016.

On Thursday, December 31, 2015, the SPX closed at 2043.94. Looking at the SPX December 2016 Options (those that expire on December 16, 2016) and using thinkorswim’s platform for options, I note the following:

• About an 80 percent probability that SPX closes above 1725;
• About an 80 percent probability that SPX closes below 2275; and thus
• About a 60 percent probability that SPX closes between 1725 and 2275 at expiration.

I arrive at these values by finding the SPX value at expiration where the put delta is roughly -0.2 and the call delta is roughly 0.2. I am using option deltas as a rough proxy for the probabilities.

The lower level is about 84 percent of the current SPX value and higher level is about 111 percent. Again, we see a skew to the downside because that implies about an 18 percent downside risk compared to about a nine percent upside risk. There is an approximately equal risk that SPX closes below 1725 as there is that it closes above 2275.

Even if the risks were perfectly balanced, there should be a skew to the downside because of dividends. Dividends make puts more expensive. So let’s adjust the put value to incorporate the dividends. SPY dividends have been about 2.4 percent. 2043.94 times 2.4 percent yields 49.05. Thus, to arrive at the amount of skew while incorporating dividends, we get a higher level of 86.8 percent (equals (1725 plus 49) divided by 2044). Thus, the downside risk of about 15 percent is nearly twice as great as the upside risk of about 11 percent.

When learning of various forecasts, remember to keep an open mind. As the opening quotation shows, Wall Street forecasters are traditionally an optimistic bunch. While option pricing models are certainly not crystal balls, they do provide a quick snapshot as to how market participants view the current market. With the passage of time, of course, that view will change. In short, I am not wildly optimistic in my outlook for 2016.

This past year was a difficult year for Albertans. With oil and gas prices at extreme lows, many oil and gas companies are struggling. Even worse, many have had to layoff significant numbers of their staff.

Last month, I mentioned that I expected oil prices would not remain in the US$30 for more than two months. After the disastrous December OPEC meeting where they failed to even agree to disagree, oil prices remain under pressure. Every country appears to be producing near or at maximum capacity as there is no production ceiling. Consequently, I am no longer as confident that oil prices won’t remain in the US$30s for two months or longer.

With oil prices forecasted to be “lower for longer,” many companies will continue to struggle and some may even perish. Companies that are most at risk are those that exhibit some or all of the following conditions:

• Relative to others, a high break-even cost of production;
• High debt to equity ratio;
• Share price has declined more than 65 percent during the past two years; and
• Large percentage dividend cuts.

For those who own shares in such troubled companies, this is a challenging time. Do you sell shares now and absorb your loss? Or, do you hope that the situation changes so that you can recoup some of your losses? There is no easy answer. You will have to assess your personal financial situation and that of each company. And, then make your decision.

While 2015 has been a difficult year and the early start of 2016 appears to be challenging, too, some analysts are forecasting better commodity prices in the second half of the year. For Albertans, let’s hope our situation improves soon.

I wish everyone a happy, healthy, and successful 2016!

In late January 2015, I postulated that oil prices were near or at their bottom. I wasn’t alone, however, as even Abdalla El-Badri, the OPEC chief, thought we were near bottom, too.

Here we are coming into the close of 2015. The question remains: As oil prices hover around the $40 mark, are they near the bottom?

This past year has surprised most experts as oil prices have stayed lower, and for longer, than most expected. Looking forward to the next few months is equally challenging. Inventories remain at record high levels, Iran and Iraq will be producing more, and the geopolitical environment is challenging. While the rig count is down substantially, US production is off only modestly.

During this past year, many capital projects have been cutback or eliminated. While those capital reductions might not have an immediate impact, over time their effect will be felt. In fact, Saudi Arabia is now voicing concerns, as evidenced in a recent Financial Times article “Saudi counters ‘lower for longer’ oil mantra” (subscription required), that the industry might not be investing a sufficient amount for future growth.

A year on, as Opec ministers prepare to meet next week with oil languishing near $45 a barrel, senior Saudi officials have a different message. In recent weeks, in public forums and private briefings, they have emphasised the dangers of future supply shortages as the oil industry has slashed investment in new projects.

Prices fell further than they ever anticipated, they say, remarks that for many in the oil market imply the Opec kingpin wants the year-long oil rout to come to a close.

Saudi officials say they are not about to reverse the policy that saw them open the taps and prioritise their long-term exports over short-term financial gain. But behind closed doors they say they want prices to stabilise between $60 and $80 a barrel.

That level, they believe, would foster oil demand but not encourage too much supply growth from alternative sources — a goldilocks scenario. Market watchers say that by focusing on the future outlook the kingdom can slowly coax the price higher without abandoning its strategy.

Back in late January, I thought oil prices might touch the high $30s, but doubted that prices would stay there for an extended period of two months or longer. While I am still of that view, I had expected that prices would have shown more strength by now.

I will be watching for any developments arising from the December 4 OPEC meeting and generally watching the oil environment over the coming weeks and months. Current prices are unstainable, so it is a question of when, not if, prices rebound higher.

Like most voting eligible Canadians, I voted in the recent federal election.

Unfortunately, I was not thrilled with my choices, neither in terms of federal parties nor in terms of local candidates. I agonized over my choices considering the parties’ different platforms, with each of their strengths and weaknesses. Ultimately, my decision was based upon my perception of the “lesser of the evils.”

Canadians provided Justin Trudeau and his fellow Liberals with a majority government. The general consensus is that Canadians wanted change. The conservatives ran a negative or divisive campaign, whereas the liberals ran an upbeat, positive, sunny campaign. Trudeau also performed well throughout, seemingly gathering momentum with each passing day. The long campaign certainly worked to his advantage.

I am pleased to see that Alberta elected a few Liberal seats, which should provide Alberta with at least one cabinet post. And, many of the constituencies ran a very close race. Perhaps this latest change signals an end to Alberta’s tendency to vote for just one party. Having some diversity is good, because that suggests Alberta will always have a voice in cabinet, regardless of which party wins.

Now that Trudeau has been elected as our Prime Minister, I wish him good luck in governing. I hope he is able to effect the positive changes that he imagined. And, where it makes sense to modify or amend his plans, I hope he is open to altering his course. Canadians have impossibly high expectations of our new government. After a few months, however, we will all have a better sense of the new direction. Although he faces many challenges, I am sure Trudeau is excited by his opportunities.