Trading An Illogical Oil Market

Interpreting economic data, “the figures” as those of us in the interbank forex market used to call them, used to be simple. If a number relevant to the dollar beat expectations, say better than expected GDP growth, or lower than expected inflation, you bought. If it was worse than expected, you sold. Simple. Now, though, it seems that we are in a kind of post-ironic world, where everyone is so determined to prove that they are “thinking outside the box” that markets frequently move in a completely illogical way after releases.

Take this week, for example. There have been three major news and data releases this week: the FOMC interest rate decision, GDP, and Core CPE, the Fed’s favorite measure of underlying inflation. The Fed hiked rates, inverting the yield curve even further, the American economy shrank for the second consecutive quarter, and inflation rose by more than expected. Put all that together, and to somebody as old as me, who remembers the boogeyman of the 1970s and 80s, it smells a lot like the dreaded stagflation.

So, how did indicators of economic well-being such as the stock market and oil prices react? Here are the 5-day charts for the S&P 500 and WTI futures (CL)…

Just to reiterate, the Fed is hiking rates into a shrinking economy, but failing so far to get inflation under control… and both stocks and oil gained on the week. If you have been paying attention, you will have heard explanations for that, but to the cynical, or maybe the realist, they sound more like excuses than explanations.

For stocks, the excuse is that it isn’t really a recession because the NBER hasn’t said it is yet and because unemployment is still low. For oil it is that high prices are about supply, not demand, and the war in Ukraine is still raging. Both sound perfectly reasonable on the surface, but if you detach yourself from the groupthink and believe the evidence of your own eyes, not so much.

The NBER is the referee when it comes to calling a recession, but they are a ref that relies entirely on video review, in that they don’t ever make a real time call, and the data on which they base their decisions are backward looking. Even if their eyes tell them a foul has been committed, they wait for confirmation before making a call. In other words, they will say when we are in a recession only when we are all very well aware that we are. That is what happened in both 2008/9 and in 2020. If we assume they will do the same again, they will call a recession only when it is obvious to everyone. By that time, the jobs market will be responding to a shrinking economy and unemployment will be on the rise, and markets will have collapsed.

As for the argument about oil, supply is certainly restricted, but that only matters in terms of price because it has resulted in an imbalance between supply and demand. If the US economy shrinks, which we already know is happening, and drags the rest of the world with it, which normally happens, falling demand will negate restricted supply and the price of oil will have to fall.

So why are traders ignoring the evidence of the news and data?

It could be, as I posited above, that it is some kind of a post-ironic hipster statement, but that isn’t really a style associated with traders. More likely, it is a sell the rumor, buy the fact effect, combined with relief that things maybe aren’t as bad as they could be. Both of those things will drive markets higher but, unless conditions change quite dramatically, neither are sustainable.

So, how do you trade in a market that is moving illogically on news? The flippant answer is “very carefully” but that isn’t much help. The way I approach it is to go with the flow, but on a short leash, and to give up some profit occasionally by reversing, just in case reality starts to set in. That means, as crazy as it seems to me, buying on initial dips or joining in a run up on bad news, but taking a quick profit. Then, if my profit-taking level happens to coincide with a resistance level, I might try reversing to a small short position, again with a fairly tight stop.

Sooner or later, markets will start to behave logically, they always do. However, as I frequently remind anyone who will listen, the market can stay illogical a lot longer than you can stay solvent. That means that you have to join in the insanity, but if you do, do so with some sensible precautions in place.