The biggest story of Wednesday’s trading was oil’s fall. WTI oil fell 3% to $42.47 which is the lowest price since last August. The 20% price decline in the first half of 2017 was the worst decline for a first half since 1997. Initially oil prices rallied because the EIA reported that inventories declined 2.5 million barrels from last week. The U.S. rig count is about to collapse from the 933 currently online. E&P firms tend to want to hold on to production until they can’t anymore which is why oil prices act violently. Violent crashes are the only way E&Ps react by pulling back production. As you can see from the chart below, the decline in production has almost completely reversed even though oil never came close to the price it was at in 2014 before the crash.

(Click on image to enlarge)

According to Barclays’ analysis, for the rig count to stay above 900, E&Ps would have to increase spending by 70% and well costs must decline. In other words, it’s impossible because high grading has already been done and is losing its muster. High grading is when firms only drill the cheapest wells. Service firms raised prices since the lows which crimped E&Ps’ gains when prices rose. There aren’t many new wells which can be profitable with oil in the low $40s. I think oil will continue to fall until shale production slows. We should see signs of this in July which means oil might stop going lower then. However, the impact on oil firms’ profits will lag that decline and the bottoming process in oil which is bearish for S&P 500 bottom up earnings.

The chart below shows the history of the real spot price of crude oil. Putting this recent price move in context makes those who want to buy the dip in oil realize that prices can remain low for decades. Using the real price destroys the misnomer that prices go up over time because of increased finding costs and increased demand. Investing in oil firms is tough because you can’t value them using traditional metrics like PE. You must have an opinion on the price of oil and breakeven costs. That’s tough because oil is so volatile and firms like to make it seem like they can make money at a lower price than they can. I’ve seen EOG Resources claim they make profits with oil at a certain price while reporting losses. It’s magical accounting which I don’t buy into.

(Click on image to enlarge)

Speaking of magical accounting, the buybacks which boost EPS numbers were finally released for Q1. I have been expecting a big increase in buybacks this year as earnings come close to their record. Q1 2017 earnings were the second highest for a quarter ever, as the peak Q3 2014 as reported earnings edged it out by a penny. I have been expecting a lagging effect as firms make their decisions on buybacks after the money is in the coffers. Therefore, I expect buybacks to ramp higher in Q2 and Q3 of this year based on the already reported results. The buybacks afterwards will depend on how future earnings come in.

Buybacks have been the underpinning of this bull market as the $3 trillion in buybacks from 2010 to 2016 make buybacks the largest supporter of the market (even larger than index fund buying). As you can see from the chart below, buybacks fell 17.5% year over year to $133.1 billion in Q1. That was a tough comparison because Q1 2016 had the most buybacks for a quarter this cycle. Directors’ approval for buybacks fell to the lowest since 2012. In Q1 the total of buybacks and dividends only fell 2.1% year over year because dividends can’t easily be cut like buybacks can. S&P 500 companies excluding financials, utilities, and transports had a record $1.5 trillion on their balance sheets.

The big determining factor for buyback growth is the repatriation tax holiday. I have always said, that was the most likely part of the tax plan to pass because it’s the most popular since even Democrats would like foreign capital to be reinvested into America. Capex is only expected to increase 2.57% to $957.9 billion in 2017 despite S&P 500 profits growing in the high single digits. There will be a lot of cash on the balance sheets if buybacks aren’t increased. This along with the repatriation tax holiday could combine to form a huge boost for stocks in 2018. Even though I expect a recession to occur in 2019 if tax cuts are passed, 2018 could be a fantastic year for stocks if these dynamics play out that way.

(Click on image to enlarge)

The chart below explains how stocks rallied despite the dip in buybacks in Q1 2017. As you can see, when ETF buying dipped in 2016, buybacks reached their record and when buybacks dipped in 2017, ETF buying it its record. The best-case scenario for stocks would be if both increase simultaneously. The higher stocks go, the more passive money will come in, chasing high returns. Technically passive investing shouldn’t chase returns and flee declines, but human nature proves otherwise. That’s my main qualm with that term. ETFs pushed stocks higher which encouraged more investors to get in even though the Trump optimism didn’t lead to any policy changes. The lack of legislation has only deterred Republican consumers slightly. If the legislation is passed, there may be a blow-off top scenario where stocks rocket higher and then crash. Given the headwind from margins reaching their ceiling, stocks might rally despite poor earnings growth.

(Click on image to enlarge)

Conclusion

Earnings growth was inevitably going to slow given that easy comparisons led to over 20% growth in as reported earnings in Q1 2017. However, it could slow quicker than expected now that oil is crashing as energy was the big reason for the earnings growth. That being said, stocks can still rally in the meantime as technology firms institute large buybacks because of record earnings and the tax repatriation holiday. That could cause a final rally in stocks in 2018, pushing valuations closer to the historic level seen in the late 1990s.