5 Reasons To Be Cautious On Expectations Of A Continued Market Rally

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 |  Includes: DIA, QQQ, RSX, SPY, VGK
by: Zoltan Ban

Summary

Geopolitical threats such as the ones in Iraq and Ukraine can derail the current stock rally. Main threat comes in the form of disruptions to energy flows.

US and Canadian oil production increase since 2008 accounts for all global liquid fuel production increase. Increasing signs of slowdown in US fields reason to worry about global growth.

The fact that median household income is down about 10% in real terms since 2007, but stocks are up about 20% since then exposes unsustainable rally.

I was away from the computer for over a month. I spent a month in Romania and a week in Turkey, with nothing but a few local TV channels providing me with clues in regards to the outside world because I made the decision to leave the laptop at home. Most international news focused on the continued mess in Ukraine and the continued diplomatic dance eagerly played by the EU, US and Russia. The stunning takeover of the Sunni-inhabited parts of Iraq by the ISIS armed group operating in Syria and Iraq, which recently declared a caliphate on the territory in Syria and Iraq it now controls also featured prominently. As far as economic and financial news go, I was completely tuned out for this period starting from the end of May to the beginning of July.

Coming home to new record highs for the market (excluding the Nasdaq) came as a bit of a surprise to me, because I thought some reaction to some of the geopolitical events would have been warranted. I also think that not nearly enough attention is being paid to increasing signs of a slowdown in US oil production gains and the implications for global growth, as well as the decline of median household incomes in the United States. The fact that the EU continues to be in stagnation mode seven years after the beginning of the economic crisis also seems to be lost on many investors. The EU is the world's largest economy when all member states are added together. The continued stagnation is making the old continent more unstable with every day that it goes on.

Threats to the market:

1) The Iraq situation is one where there is no possibility of a happy outcome from the market's perspective. If the ISIS movement continues to be successful in capturing more territory and ridding Iraq of its Shiite-led government, it will be a huge disaster. If they win against the Shiite majority, they can capture the oilfields in the South, potentially causing a major disruption to the already tight global oil market. After consolidating its power in Iraq, it could threaten Kuwait and Saudi Arabia.

Logic would dictate that the happy outcome would be the defeat of ISIS by the current Iraq government. Problem is that it would automatically be followed by another conflict with the Kurdish autonomous region which is backed by a far more powerful militia than ISIS, namely the Peshmerga. It is a well-organized and disciplined fighting force with conventional military equipment, including tanks and artillery and they number in the hundreds of thousands. During the ISIS drive through Sunni Iraq, the Kurds occupied the Kirkuk oil facilities taking advantage of the retreat of the Baghdad forces. A victorious Baghdad government would most likely want to take the fields back as well as prevent the Kurdish region from separating.

Iraq is likely to end in a bloody conflict at this point no matter what the outcome. One of the first victims of this internal conflict will be each other's oil infrastructure, which both sides will target any which way they can in order to destroy each other's economic base. There is now a great chance that Iraq's 3 mb/d + production volume will be knocked off the market and it may stay off the market for a long time. The spare capacity to make up for this loss exists mainly on paper and in conflict situations such as Libya and Iran. The markets are definitely not pricing in this risk. A prolonged absence of such a high volume of oil from the market with no real way to make up for most of it would grind the global economy to a halt.

The one other aspect of this situation which it seems everyone is ignoring is the impossible position that the situation imposes on Saudi Arabia. If ISIS wins, it is a direct threat to the kingdom because ISIS will have many sympathizers within Saudi society, which will make the regime vulnerable to any incursion by the new Caliphate. If Iraq's current government wins and the Kurds separate, the new Iraq will become a very close ally of Iran which is currently directly responsible for keeping Iraq's government from collapsing through its military intervention. The new Tehran-Baghdad axis will leave the Saudi position in the region much-weakened. The two countries together will be able to wield as much influence in the global oil market as Saudi Arabia. The Shiite alliance will also be far more powerful militarily given the numerical advantage, as well as a more developed industrial base. There is a chance that Saudi Arabia may pick its own militia groups to sponsor and support in Iraq, which may be independent and even opposed to ISIS, but still Sunni. Such a move could lead to a wider regional confrontation with the two regional big boys, Saudi Arabia and Iran coming in direct conflict.

2) The on-going Ukrainian conflict is the geopolitical event I have been warning about this year. I first of all warned that rhetoric coming from politicians and the mainstream media was not to be taken at face value. I pointed out that given Russia's very prominent position in supplying fossil energy to the world, serious sanctions were never an option, because an economic confrontation would lead to mutually assured economic destruction. As things stand right now the Russian rubble is only down a few percentage points for the year, while the (NYSEARCA:RSX) which was sold off so enthusiastically dropping from 30 points to 21, is now almost fully recovered to a level of 26-27 points, which in my view means that most of the Ukraine related sell-off was made back. Those who saw through the rhetoric and were able to grasp the reality were able to gain nicely from this rebound.

I also warned that the gas supply flowing through Ukraine to Central and Southern Europe is in real danger due to the internal Ukrainian conflict. Countries being supplied by pipelines going through Ukraine include EU members Romania, Hungary, Austria, Italy, Slovakia, Greece, Bulgaria and others. This whole region was hit hard by the 2008 financial crisis, therefore a disruption of gas this winter would be very bad given that governments, firms and households are all very vulnerable to a potential economic downturn. There may be massive defaults which the IMF may not be able to deal with, especially if it will involve either a large number of countries or a large country such as Italy. That is why the June 16 gas shutoff to Ukraine is a potential danger to global markets. If the issue does not get resolved by winter, there is a good chance of a long-term gas shutoff for parts of the EU as Ukraine will not be able to resist the temptation to siphon the transiting gas for their own use, especially if the winter will be cold. While everyone is busy looking at the conflict in Eastern Ukraine and the continued sanctions game of the US and the EU, this crisis is slowly going to heat up as soon as the temperatures in the region will start to cool down. We are just a few months away from the Ukrainian heating season and they are about 200 billion cubic feet short of what they will need (link). Things may get far worse if there is no agreement with Russia by next winter, because this year there are still the supplies in storage that Ukraine can rely on. By next winter the shortfall might be as much as a trillion cubic feet.

3) The EU is economically and socially more fragile than most seem to realize. Economically speaking the Euro zone unemployment rate is now double that of the US, sitting at 12%. May industrial production figures suggest that the feeble recovery is stalling out (link). Growth is almost non-existent, government debt is a lot higher than it was at the beginning of the crisis and the overall sentiment is now one of growing Euro-skepticism and frustration, especially among the young people who feel like they belong to a lost generation which will never recover. To make matters worse a gas dispute between Russia and Ukraine due to Ukraine's inability to settle its bills can harm the EU within a matter of months as I already pointed out. It is a region that is among the most vulnerable economically speaking, which also makes it a potential geopolitical hot spot given the level of frustration now present in EU society. The message sent by the EU electorate which elected far right and other Euro-skeptic politicians to hold almost 30% of the EU parliament seats this year, fell on deaf ears. It was the last chance for the EU mainstream to wake up and make the changes needed in order to avoid a complete loss of credibility. In the absence of immediate measures meant to improve growth prospects, a Euro crisis could erupt soon, complete with riots on the streets and other destabilizing effects.

4) Tightness in the oil supply is another major reason to doubt the sustainability of this market going forward. If we look at total global liquid fuel supply growth since 2008 it is the United States which provided most of the increase experienced so far. Canada also contributed significantly. Between the two countries liquid fuel production increased 4.5 mb/d, while global production increased 4.3 mb/d according to EIA data. It is true that global output would have increased when excluding the US and Canada if we were to ignore the geopolitical events which contributed to the drop in production, such as the conflict in Libya. Nevertheless these disruptions are a reality and there is no reason to expect further disruptions not to occur in the future.

As far as continued expansion of liquid fuels production coming from the US and Canada, it is not likely to follow the same path as it has since 2008. The Bakken and Eagle Ford shale oil fields are experiencing a slowdown, with production per well at the Bakken having peaked at 140 b/d in 2012. For 2014, the average production per well is 126 b/d (link). With total wells increasing by a smaller and smaller percentage every year, and well additions per year not increasing, it is a certainty that production increases at the Bakken field will become more modest with every passing year. In 2013 already production growth was smaller than in 2012. All indications are that 2014 production growth will be more modest than in 2013.

At the Eagle Ford, EIA data shows us that legacy production decline is accelerating. It increased by 35,000 b/d just since last October, reaching 115,000 b/d which needs to be replaced each month just to keep production steady. Having to replace so much production capacity each month will take its toll on production. So far this year production is up about 120,000 b/d. By the end of the year it will be higher than this figure, but the gain will be nothing like the 315,000 b/d gain experienced last year. According to 2014 data published by the Texas Railroad Commision, while oil production may be up, condensate liquids as well as natural gas production are lower than the 2013 average.

The Permian Basin in Texas may have some potential for the year, but aside from that, most other fields and regions are going to be a drag on production rather than a driver of increasing flows of liquid fuels in the United States. There may be many more years of production gains ahead, but the rate of increase is now clearly on a diminishing path.

5) A huge disconnect exists currently between two important sets of data. The Dow Jones, the Nasdaq and the S&P are all up over 20% since the old highs reached in 2007.

^SPX Chart

^SPX data by YCharts

US median household income as of 2012, which is the last year available is down about 10% when adjusted for inflation. Some early indications suggest that 2013 is the year that we turned the tide and real median income is on the rise again, but personally I don't believe that it will surpass the 2007 level or the all-time high reached in 1999.

Data source

Keeping this fact in mind, it is hard to justify these new record highs achieved in the stock market. It gives credibility to the suggestion that it is an artificial level caused by current monetary policies. There may be an argument to be made that there does not need to be a correlation between US median household income and the direction of the stock market, because after all most companies listed depend on the international markets for their sales. That may be true, but the other major global consumer, the EU, is in even worse shape with unemployment at 12% and the developing world is not expanding as it used to either. Add to it a US consumer base where the median data shows that at least half of all households are worse off than they were in 2007 in terms of real income, therefore are most likely to consume less in the long-term and we get a good argument for expecting a major market correction to happen at some point in the future. It could happen a few months from now or a few years from now, but it needs to happen in order to bring things back into balance. My guess is that it will happen as soon as interest rates start rising and consumers which are obviously under financial pressure will lose the one support they had since the global crisis, which made it possible to spend more on goods and services and less on interest on their debts.

While there may be some reasons to be bullish on market expectations, we cannot ignore the downside potential. I listed five factors, any one of which has the potential to end the current rally on its own, including some that could cause painful losses. Betting that none of these factors will pose a threat to investors in the near future is quite a gamble in my view. The odds of it paying off are not looking very good at the moment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.