Stocks Have Crude Awakening

We believe that oil prices are quickly approaching an important intermediate-term peak

The stock market pulled back for the second time in three weeks as the major indices react to a spike in crude oil prices and deal with a pile of overhead supply. The S&P 500, DJIA, and Nasdaq are all dropping back toward their recent breakout points, and we think it will be very important for the indices to bounce off of these important support levels. While crude oil is in a very powerful uptrend, we believe that oil prices are quickly approaching an important intermediate-term peak, and believe this may take the temporary lid off of stock prices.

Predicting an end to a runaway market is not an easy undertaking and feels like stepping in front of a hurricane. We pride ourselves in sticking our neck out once in awhile, and loath those prognosticators who wait until markets reverse directions to make a call. We'd rather be out in front of a market than sheepishly follow a market.

So what do we see technically that suggests that the stock market and consumers may get some relief from runaway crude oil and gasoline prices? Well, it's a combination of many factors, we see as all very important. To begin with, prices are extremely extended to the upside, and are a great distance from the last real base and are also a great distance from some key long-term moving averages. While it doesn't feel like it right now, prices do not move in one direction forever. We liken it to a rubber band. When prices get stretched too far, they ultimately snap back.

One way to measure how extended a market is, and one that we think is more descriptive and visual compared to momentum indicators like the relative strength index (RSI), by comparing current prices to a longer-term moving average. Oil prices are an incredible 44% above their 65-week exponential moving average. This is the most extended prices have been from this particular average since the Gulf War spike in crude prices in 1990. Including 1990, prices have moved 40% or more above the 65-week average on four occasions, and in three of those instances, prices corrected hard and rather quickly. The one time they did not correct quickly was in 1999 and 2000 when oil rose another $10/barrel or 40%, and did not peak for about a year. The character of that time period was much different as prices were trading in a massive trading range, and therefore not at all extended from a price base like the situation today.

Secondly, crude oil prices have run up to both long-term and intermediate-term trendline resistance in the $133 to $135/barrel area. The long-term trendline is drawn off the intra-week highs in 2003 and 2005, and because of its longevity as consistent resistance, it is therefore very important, in our view. The shorter trendline with a bit less significance is formed off the price highs or channel that has been in place since January. Looking at the price channel since January and comparing the advance to the complete rally that began near $50/barrel in January 2007, it is evident that the slope of the advance has steepened. In addition, the slope since the beginning of May is starting to approach a parabolic state. Many times, the end of a strong advance is characterized by an ever increasing slope, as speculation and momentum take over.

Prices have also traced out a 5-wave advance (3 up, 2 down) since January 2007, and it appears that the 5th wave is close to completion. In addition, sentiment is extremely bullish towards crude oil, natural gas, heating oil, and gasoline, and this suggests that too many investors are sitting on the fence, and if they don’t start shifting back to neutral or bearish on the oil market, we think the fence is going to break and there won’t be a door big enough to run through.

Lastly, oil prices have once again moved to the front pages of the newspapers and magazines, and have taken over as the main topic on business channels and well as the nightly news and local news. It has quickly replaced the credit crisis as the number one worry, in our view. It is the topic du jour at investment policy meetings as well as around the water cooler. When an asset is discussed this heavily, we think that a top can not be far behind.

The S&P 500 has pulled back to its breakout zone in the 1370 to 1380 range. Many times, a drop back to levels near an assets break point is common, but a decline below this area would be technically negative, in our view. Therefore, the near-term price action is very important to our semi-bullish call. In addition to critical chart support, the 50-day and 65-day exponential averages sit at 1383. Many times after a breakout, prices will get extended from short- to intermediate-term averages, but then come back in line and test these averages. A 38.2% retracement of the recent rally, using closing prices, comes in near the 1370 level.

The recent rally failed right at the 200-day simple average, which now sits at 1427. The S&P 500 had rallied into a wide range of thick chart resistance that runs all the way up to the highs from last year. As we said, it takes time to eat through so much supply of stock, and every now and then, prices have to back up before they can take another run to the upside. Momentum has rolled over on a daily basis, a warning about the near term price action. On a weekly basis, momentum has bounced from oversold territory but never moved into bullish territory. Part of the reason for this is simply due to a lack of time associated with the rally off the March lows.

We will nervously watch oil prices along with the masses and hope that our bearish call is timely and clairvoyant. If not, the upside breakout by so many stock indices will turn out to be the great fake out of 2008.

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