- The United States Oil Fund, which invests in oil futures contracts, was guaranteed to be a losing bet over time because the price of long-term oil contracts were higher than the spot price.
- Still, retail investors piled into the exchange-traded fund, perhaps believing it was a bet on the spot price of oil.
- The market is displaying a V-shaped recovery even though the economy is not.
Long-time professional traders watching the near implosion of the United States Oil Fund could only watch in wonder.
"It tells me people always want to make a quick buck," said John Davi, chief investment officer and founder of Astoria Portfolio Advisors. He was referring to retail investors who lost a boatload of money investing in this popular exchange-traded fund that trades under the symbol USO.
The USO invests in oil commodity futures contracts. Oil was in contango, which means the contracts farther out were more expensive than the front-month contracts and investors were guaranteed to lose money over time.
When the difference between the front-month contract and the contracts farther out reached an insane spread, investors lost a ton of money.
The dangers of investing in these type of futures investments has been known for years. And yet a slew of retail investors piled into the USO in the last few weeks, swelling its assets under management.
"It's inevitable that people would want to bottom-fish," Davi told me, noting that investors mistakenly thought they were buying a product that tracked the spot price of oil.
Why would investors pile into such a risky investment?
"I don't think a lot of people understood contango very well," he said, noting that retail investors often lose money. "Think about penny stocks and how many people lose money in them," he said.
Still, enough damage has been done that Davi believes the ETF industry and investment advisors will have to get more aggressive in protecting investors. "There should be a disclosure you sign before you are allowed to trade these futures-based products," he said. He feels the same way about the proliferation of leveraged and inverse ETFs. "Do you really need a 3 times levered ETF?" he asked.
Another common gripe of retail investors: the speed of the rally. Since the bottom on March 23, the S&P has recovered more than 50% of its losses. It's down only 17% from its historic high on Feb. 19.
That strikes many as odd, as almost no one is expecting a V-shaped recovery in the economy. But that is what the chart looks like.
For Stadium Capital's Joe Zicherman, who has been trading stocks for more than 40 years, first with Merrill Lynch, then Morgan Stanley, and now his own money, there's a simple explanation: "The market has come to believe that the Fed cannot fail."
"Marty Zweig famously said you cannot fight the Fed," he said. "When Larry Kudlow said, 'We have bazookas in reserve,' that's a 500-page book in one sentence."
Zicherman said the whole theory that the Fed would be "out of bullets" was simply wrong. "The Fed put is not dead," he said. "They're backstopping corporate bonds, high-yield bonds, and munis. They will backstop anything — that's what they are telling you."
Many investors have insisted the market will retest its lows, citing the market dip in late 2008 before the market finally bottomed in March 2009.
Davi insists there's an important distinction between 2008 and 2020.
"The speed and velocity that the Fed and congressional relief packages came out was very different," he said. "In 2008, it took many months to get the rescue packages together. With this, it took a couple weeks, and there was more direct aid to individual people," noting the Fed was even more aggressive than in 2008.
Still, plenty of investors agree that the economy is signaling a much bigger slowdown than stocks are pricing in.
One of them is Peter Cecchini, senior managing director at Cantor Fitzgerald. "The equity market is behind the curve on this," he said. "It is not appreciating the severity of the economic situation. Not just because of the pandemic, but we are in the midst of an oil price shock that is a big blow to inflation. Also, people did not appreciate that the economy was slowing going into this and valuations were too high."
The current economic climate, he said, "is not enough to justify an S&P 2,800."
He sees several execution risks that will threaten the rally in May: first, an acceleration of new infections in the first wave of states that reopen; second, greater difficulty in coming up with effective treatments; and finally, the data and earnings will be worse than people expect.
"Companies are going to miss, they are going to miss badly, and as companies pull their guidance and miss more than expected, it's going to be a problem," he said.
Where does that leave investors? Davi says he is bullish on the stock market, bearish on the economy: "I don't want to own real estate where people have to pay rents, but Visa, Microsoft, Mastercard ... that's different. You're paying for companies with strong balance sheets. These companies are going to survive."