Stocks, Oil, and Bonds

A barrel of oil bounced to over $60 Thu, which triggered a steep sell-off in the stock market Thu and Fri, although oil pulled-back to around $59 a barrel, and closed at $59.84 a barrel Fri.

There are many reasons why oil prices are high, including a "price premium" for potentially negative geopolitical events, the start of the hurricane season Jun 1st (which may affect refineries in the Gulf), the 4th of July holiday (which is the start of the summer driving season), and end-of-the quarter window dressing (which may keep oil prices and oil stocks high). However, the most influencial factor is stronger than expected global economic growth. Both U.S. monetary and fiscal policies remain stimulative, and the global economy continues to expand at above trend growth. Moreover, financial markets have not slowed the global economy through negative "Wealth Effects."

The price of oil has a weaker influence on U.S. producers, because the U.S. economy has become lighter (for example, the products Microsoft produces weigh little). Nonetheless, high oil prices will have some negative effect on earnings, particularly producers of heavy products (e.g. in China, which is moving from the Agricultural Revolution into the Industrial Revolution, while the U.S. is moving from the Information Revolution into the Biotech Revolution). Also, U.S. productivity growth is slowing, which is negative for earnings. On the consumption side, a higher oil price is a tax, because consumers substitute other products for higher priced oil products. So, demand or prices for other goods fall. Consequently, a higher oil price will slow output growth and lower living standards rather than cause inflation.

The four charts below are same period daily charts of SPX (S&P 500), OEX (S&P 100), OIH (oil stocks index), and TLT (long bond ETF). SPX (the largest 500 stocks) has outperformed OEX (the largest 100 stocks) for several years. Currently, OEX is relatively undervalued compared to SPX. The four charts show the general stock market (i.e. SPX and OEX) OIH, and TLT generally rallied together recently. However, they may move in different directions over the next few weeks.

The first chart shows SPX fell to the congestion area (circle), which is a major short-term support area. Also, SPX 1,192 has been a major (support and resistance) level, for several months, although SPX closed at 1,191 1/2. The Price-by-Volume bar (on left side of chart) shows additional support at 1,180 to 1,190. Both the 50 day MA, currently at 1,181 1/2 and the 200 day MA, currently at 1,174, are rising. Major resistance is in the low 1,200s (psychological resistance at 1,200, 10 and 20 day MAs, and top of congestion area). SPX has created a bearish head & shoulders pattern so far this year. There are open gaps at 1,174, 1,143, and 1,138, which may close this summer. End-of-the quarter window dressing by Thu, new quarter on Fri, and the 4th of Jul holiday Mon may be bullish for the stock market next week.

The second chart shows OEX fell below major support levels over the two day sell-off, i.e. below the 10 20 50 and 200 day MAs, below the congestion area (circle), and below the Price-by-Volume bar in the mid 560s. Next major support is in the low 550s, which is the middle of a previous congestion area. Major resistance is at 564 to 567 (where there are several resistance points). Over the past five years, the OEX to SPX ratio fell from 57% to 47%, after rising from 46% to 57% over the previous five years. Moreover, OEX underperformed SPX over the past two months. So, OEX is relatively undervalued compared to SPX.

The third chart shows OIH rallied from just over $84 to over $105 a share, while oil rallied from $47 to $60 a barrel. If oil is in a $50 to $60 range, then OIH may consolidate and fall to the mid-$90s a share. The fourth chart reflects falling long bond yields recently (since TLT and long bond yields move in opposite dirctions). Also, the flattening of the yield curve recently is predicting slower economic growth. Global economic growth is likely to slow over the next year or two, since the global economy cannot maintain above trend growth. Consequently, both the stock market and oil prices should fall (i.e. SPX OEX and OIH). However, slower disinflationary growth or slower inflationary growth (i.e. stagflation) will determine TLT.

Economic reports next week are: Mon: None, Tue: Consumer Confidence, Wed: Final GDP and GDP Chain Price Deflator, Thu: Personal Income, Personal Spending, Unemployment Claims, Chicago PMI, and the FOMC announcement, Fri: Construction Spending, ISM Index, Auto Sales, and Michigan Consumer Sentiment. There are notable earnings reports only on Wed: ORCL RIMM GIS COMS MON TONS.

There may be excellent option trading opportunities next week. If the price of oil pulls-back, OIH may fall, while SPX and OEX may bounce (although, longer-term SPX OEX and OIH may fall). TLT may fall after the FOMC announcement Thu, since it may maintain its balanced stance on growth and inflation. Perhaps, OIH will trade between 100 1/2 and 104 1/2, while OEX trades in the high 550s to high 560s. TLT may pullback one or two points, and major support is at 93 1/2. A heavy producer e.g. X (U.S. Steel), which is beaten down, may rise on a pullback in oil prices. SPX puts may be a buy at 1,200. The Dow Industrials fell from over 10,600 to below 10,300 Thu and Fri (The Dow bounced sharply off 10,000 two months ago). So, DIA calls may be a buy. There also may be an excellent opportunity to make gains on earnings, e.g. GIS calls.

See http://www.peaktrader.com Forum Index Market Overview section for charts.

Arthur Albert Eckart is the founder and owner of PeakTrader. Arthur has worked for commercial banks, e.g. Wells Fargo, Banc One, and First Commerce Technologies, during the 1980s and 1990s. He has also worked for Janus Funds from 1999-00. Arthur Eckart has a BA & MA in Economics from the University of Colorado. He has worked on options portfolio optimization since 1998.

Mr Eckart has developed a comprehensive trading methodology using economics, portfolio optimization, and technical analysis to maximize return and minimize risk at the same time. This methodology has resulted in excellent returns with low risk over the past three years.

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