Much has been made of the observation that the current stock market is ‘oversold’. What does that mean? Better yet, why do we care?

Oversold and it’s diametrical opposite overbought are technical terms, technical in the manner of chartist jargon, not really technical at all, almost the opposite. We get oversold when stocks have been sold for day after day after day. So, what does that mean?

On any given day, even on extreme days, some stocks go up, others go down. One stock’s meat is another stock’s poison. Even on Black Monday back in 1987 there were numerous stocks that rose that day, there were even new highs (mostly gold shares and closed-end bond funds). But, when more stocks get sold than bought every day, day after day, we can get oversold. We have always considered it more a breadth thing than a price thing, but there are several definitions of oversold.

During corrections and bear markets stocks can get oversold and then stay oversold for a long time. But, in bull markets oversold conditions generally don’t last very long. Once the market gets oversold, it may not take all that much to get a nice bounce from prices. That is one of the reasons why technicians try to score the market on this basis and why they even care.

Stocks are oversold these days. Just like stocks were overbought back in February and again in late April. The reason we think stocks are oversold has nothing to do with our contention that stocks are cheap or not. This is very short-term oriented stuff. Just like you can be mad at your kids and love them at the same time, stocks can get overbought and be cheap and oversold when they aren’t.

So, why does it matter that stocks are oversold now? Because the reason stocks are oversold has almost nothing to do with stocks but with this heinous risk-on/risk-off business. On a daily basis, as much as two-thirds of the share volume can be traced to very short-term oriented, high-frequency trading systems. These traders are just trying to skim a few basis points of return out of the market by exploiting small arbitrage opportunities. They may trade in and out of the same stock several times a day if the volume and price action permit it. It is rather sick really, but it is a good living for the trolls who do it. Also, the brokers who make these trades for the trolls like it. So, hardly anyone mentions how the trolls are impacting everything good and likeable about the market.

Between the trolls and the hedge funds the rest of us get jerked around a lot. But, the risk-off trade sends spasms of trading through the market as hedge funds and some institutional managers sell to reduce the risk profile of their portfolios and this creates the small arbitrages that feed the trolls. The most recent example is when Greece was trying to roll-over their most recent debt maturities and trying to get some extra money to pay their civil servants, pensioners and others. Because the Greeks worried the Euro traders, the Euro dropped, the dollar rose. That triggered a flight from stocks because financing the stocks with borrowed dollars became too expensive. We have the Greeks to thank for a much lower market. But, they weren’t that only ones. The Chinese raised reserve requirements which strengthened the renminbi, of course the dollar was down and the whole thing reversed.

We’ve had weak economic numbers, persistent financial crises, the Weiner affair, Newt Gingrich and all the other distractions lately. The short of it is that none of this really matters all that much to what we ought to be willing to pay for stocks. But, due to the crazy way we allow some traders to play with excessive leverage and rapid trading, we have a market with excessive volatility and no discernable direction.

Issue of the Week

Our friends and enemies at the Organization of Petroleum Exporting Countries, or OPEC, met at their headquarters in Vienna, Austria last week and decided to leave their current quotas for oil production unchanged for the third quarter. This was an unexpected result as the market had widely expected the cartel to raise its self-imposed quotas to reflect increased demand from emerging nations and heightened production from the members themselves.

It is widely known that most of the OPEC members are producing all the oil they can produce. For some of them, notably Iran, the quota is more than they can produce and so that quota goes to waste. Most are cheating, producing more than their quotas permit. The last time there was broad cheating, OPEC just raised the quotas to levels close to what the cheaters were already producing. This time, the producers who cannot increase production blocked the few who could increase production from getting higher quotas.

There is more than complex economics behind all these moves. There is a whole lot of global politics and religious hatred besides ancient animosities. Iran holds the rotating presidency of OPEC this year. Iran will do just about anything it can to undermine the Saudis, the Kuwaitis and the gulf Emirates. Those are the OPEC members who would have gotten most of any increase in output. As it is, these guys will probably just continue to produce above quota like they have been lately. But, Iran may not just ignore their violation.

It could be time for OPEC to close up shop. The point of OPEC was to get oil prices higher when oil was $3 a barrel. The economics of oil prices were much easier to manipulate back then. If the OPEC nations cut production, oil prices would rise. A 10% production cut might lead to a 50% increase in prices. OPEC became a force to be reckoned with after the first Arab Oil Embargo in 1973. Incensed by the victory of Israel in the Six-Day War, Arab members of OPEC embargoed oil to the United States and Western Europe. Prices more than quadrupled. There were shortages in all the effected nations with economic repercussions. This lead to the global recession in 1973-1974.

OPEC again reduced output in 1978 after the Yom Kippur War, and again got a near quadruple in the oil price. However, unlike the gains in 1973, this price increase had a very negative impact on world demand and in the early 80s oil prices fell again. So, the price went from $3 a barrel to $12 in 1973, then went from roughly $10 a barrel to $40 in 1978. But, by 1986 prices were back to $10 a barrel. It looked like OPEC was no longer necessary or important.

Also in 1980, Iran and Iraq went to war, causing a huge problem for OPEC. In a surprise, it was Iraq that was drummed-out of OPEC for being the aggressor in the fight. The Iran-Iraq War limited the supply of oil from both nations, though not as much as you might think. Both nations continued to supply crude to the world oil market, though both saw disruption of their production. Iraq has never been readmitted to OPEC, though they send a representative to the meetings.

OPEC has a long history of cheating on quotas. When the benefit of cheating is great and the cost of getting caught is almost nil, cheating abounds.

Making any of the foregoing even remotely relevant, we have OPEC not raising their quotas while the oil markets are supposedly ‘tight’. The revolution/civil war in Libya is taking about 2 million barrels of oil out of the daily supply. Saudi Arabia is making up all of that and could do more if they wanted to. So, the oil markets aren’t all that ‘tight’. For OPEC to make the market ‘tight’ they’d have to actually cut quotas and then find some way to enforce the lower quotas. While we may see headlines that oil prices will just have to go up because OPEC decided to do nothing at this meeting, this is preposterous. OPEC is only as strong as the Saudis. If the Saudis want higher oil prices, they can engineer that. If they want lower oil prices, they can engineer that.

Today, with the futures market running the oil markets, it might be time for OPEC to close-up. They have already lost a couple of members whose oil essentially ran out. More members will face this in the future. Of the current members, only a few could produce more oil than they currently do and few have any desire to hurt the global economy just for a couple of extra bucks a barrel. What’s the use of a cartel except to raise the price?

Economic News

The US trade deficit narrowed in April to $43.7 billion from $48.6 billion in March. Most of the decline was blamed on reduced trade with Japan after its earthquake and tsunami disrupted manufacturing and trade there. Imports from Japan fell by a record amount. Oil imports also fell by 13.8% despite a rise in the price of crude. US exports hit another record level. So, with record exports, a huge decline in trade with Japan that will probably be reversed shortly and a big drop in oil imports, we still ran a huge deficit?

Weekly Stuff

Stock markets the world over were kicked pretty badly last week. It was hard to find markets that had gained, let alone gained anything worth mentioning. It appears that Mexico was barely up and Japan was about break-even for the week. Other than that, it was pretty dismal out there.

US stocks fell by 3% or more among small caps or on the NASDAQ. The more dependable S&P 500 and Dow Industrials were only off 2% and 1%+ respectively.

Foreign indexes were likewise off a couple percent with currency making up a lot of the total return drop for US investors.

Bonds had a pretty decent week mostly, if you bought Treasuries or a foreign equivalent. Corporate bonds didn’t fare as well, and high yield bonds did more poorly yet, but still better than stocks. The dollar strength last week cut into returns for foreign bonds when returns were translated back into dollars.

The dollar gained over 1.5% on the week, or should we say that the Euro fell 2% and dragged many other currencies with it.

Real estate securities were particularly hard hit. With a widening view than the global expansion is losing steam, it was difficult to justify the high prices for real estate securities in most markets.

Commodities were mixed, which almost sounds like a throw-away line most days but is actually true this time. There was a definite pattern to the chaos in the pits, with energy prices higher (see above for some insight there) while grains and livestock fell and industrial metals, precious metals and most softs were down. Energy prices are sucking all the air out of the market for any other type of strength.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.