Reminder: Watch Out for the “Pain Trades”

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Sometimes the reasons for betting on or against a certain investment seem compelling. Not only do various rationales appear supportive when viewing things from the bottom up, they are often confirmed by a top-down perspective. And yet, it is not unusual for these supposed no-brainer trades to fare badly. The result can be heavy losses for those who believed they were sure-fire winners.

In fact, some might characterize such situations as the very definition of a “pain trade,” where all the ducks appear nicely lined up, but where “Mr. Market” nonetheless manages to punish those who are confidently positioned this way.

Take the energy markets, for example. There has been a steady stream of news reports and commentaries suggesting the path of least resistance is down, despite the fact that crude prices have already fallen by roughly two-thirds over the past 20 months. Supplies remain ample amid reports that owners are using tankers and railroad cars as temporary storage facilities, while demand seems less than robust, to say the least.

Plenty of supply…

The supply side of the equation looks particularly daunting. The Saudis have made no attempts to alter their strategy of flooding markets with oil in an effort to drive out marginal producers and protect their global share. That is despite evidence that the collapse in prices is doing serious damage to the country’s finances and economy. At the same time, other producers, inside and outside of OPEC, have not been inclined to scale back production, including Iran, which is now free to export more oil due to an easing of sanctions against that country.

Meanwhile, one of the intended targets of the Saudi-led initiative, U.S. shale oil producers, have, on balance, continued to pump out crude despite the fact that most are reportedly losing money on every barrel. For smaller operators, in particular, the goal seems to be to hang on in hope until prices rebound, or to generate enough cash to keep their businesses from crashing into bankruptcy.

…and a shortage of demand?

Things don’t look much better on the demand side. While there is considerable debate about whether or not the U.S. is heading into recession–see here–it is clear that economies in many parts of the world, including China, the world’s largest energy consumer, and other developing countries, are faltering. In part, this reflects an ongoing retrenchment from the earlier boom in commodity prices on the heals of unrealisric expectations about future prospects, as well as stretched public sector finances in many countries.

And yet, despite these bearish fundamentals–not to mention a steady onslaught of negative newsflow on the state of the energy market–crude oil seems to be bottoming. The price of West Texas Intermediate, or WTI, has risen more than 25% to $36.20 a barrel over the past month or so, and is rapidly approaching its highs for the year.

One reason for the run-up is lopsided sentiment. For markets that manage to rally in the face of overwhelming negativity, the classic maxim is that there is “nobody left to sell.” Although that statement is not usually meant in a literal sense, the fact is that investors can and do get carried away by their faith in certain perspectives, even if the arguments are widely known and presumably fully factored into prices.

Pausing for a reversal

At that point, all it might take is a momentary pause in momentum before nervous traders start pulling chips from the table. With so many participants playing things from the same side, a bout of profit-taking by a few can quickly escalate into something larger, especially when those who’ve racked up big gains start worrying about giving back a chunk of unrealized profits. In the case of the oil market, the fact that prices stalled once they fell below $30 amid widespread talk–and media speculation–that $20 was the next stop was enough to force some bears to rethink their pessimism.

Knowing who is doing what on each side of a trade can provide some insight about where things are heading next. In the oil markets, large speculators, notably hedge funds, have been reducing net long futures positions since July, based on data compiled by the Commodity Futures Trading Commission in its Commitments of Traders report (COT). In contrast, commercials–producers and others in the energy industry–who are often viewed as the most knowledgeable when it comes to underlying supply-demand fundamentals, have been closing out short positions, suggesting they were becoming less concerned about further downside risk.

Fundamentals turning positive?

Needless to say, fundamental developments  may have also played a role in turning the oil complex around. While the conventional wisdom is that the markets have far more supply than anyone knows what to do with, some analyses suggest it won’t be long before production and demand are in balance–or, by some accounts, in deficit. In fact, following a 3-year uptrend, U.S. output has fallen by 5.5% since June of last year, based on data from the U.S. Energy Information Administration, suggesting that lower oil prices are, in fact, having the anticipated impact on production.

The point is, even though many might maintain that there is no reason for oil to rise, it has nevertheless done so. Whether it proves to be the countertrend pause that refreshes the longer-term downtrend, or whether, in fact, the market is in the midst of a tanker-like reversal of fortunes, the recent rally is typical of what can happen in markets where perspectives–and positioning–lean overwhelmingly To one side.

In hindsight, that probably meant one thing, In particular, as 2016 unfolded: the pain trade for oil markets was up. More broadly, it is also another reason to keep in mind that out-of-favor ideas and investments can abruptly come back into fashion (like here, for example), and what seems “just right” can turn out to be so wrong.