WATCHING THE OSX AND THE SOX -- MONEY MAY START ROTATING FROM AN OVERBOUGHT ENERGY SECTOR INTO AN OVERSOLD CHIP GROUP

OIL SERVICE INDEX GIVES SHORT-TERM SELL ... I wrote yesterday that the oil service group (and the rest of the energy sector) had issued a short-term parabolic sell signal from an overbought condition. The short-term trend of the Oil Service Index (OSX) weakened even further today. Chart 1 shows the OSX closing under its 20-day moving average for the first time in two months. That suggests a further decline to the lower Bollinger Band or its 50-day moving average (see box). The daily MACD lines (on top of the chart) also issued a short-term sell signal. The relative strength ratio (below the chart) has fallen under its moving average line for the first time since August, which reflects at least a temporary loss of market leadership. Crude oil fell over a dollar today after hitting a record high intra-day. That's the way it usually happens. Stocks related to a commodity usually turn before the commodity. Interestingly, basic material stocks also fell today signaling an overbought commodity sector. Copper and gold prices fell. I happen to believe that these commodity pullbacks are corrections to major uptrends. However, any sign of weakness in crude oil could help launch a fourth quarter market rally. But that's only half of the story. For a serious market rally to materialize, I also believe that the market needs more help from the semiconductor group.

Chart 1

SOX TESTING 50-DAY AVERAGE... I've written before that a strong oil group and a week semiconductor group are a bad combination for the stock market. Part of my recent optimism for a fourth quarter market rally has been predicated an a likely pullback in oil and signs of a bottom in the chip stocks. After rebounding during September, the Semiconductor (SOX) Index has been pulling back. It was one of today's weakest groups. However, no serious chart damage has been done. Chart 2 shows that the SOX is simply retesting its 50-day average. What the SOX does from here is important. Part of today's weakness came from late selling of Intel in advance of this afternoon's earnings report. Right after the close, Intel jumped over 2% in after-hours trading on that report. That may lead to some buying of the chips tomorrow. It would come just in time and, combined with weaker oil, could give the market a needed boost.

Chart 2

SOX/OSX RATIO MAY BE TURNING UP ... Chart 3 plots a ratio of the SOX Index divided by the Oil Service (OSX) Index going back to the start of 2002. Generally speaking, a rising ratio (SOX doing better than the OSX) has been good for stocks. The ratio bottomed in October 2002, and again in the spring of 2003, and helped launch the current cyclical bull market. The peak in the ratio at the start of 2004 (chips underperforming energy) started the market's 2004 downside correction. Right now, the ratio is sitting in potential support at the late 2002/early 2003 lows. This would be a logical chart spot for some rotation to begin out of an overbought oil sector and into an oversold chip sector. If that were to happen, that would go a long ways toward launching a yearend market rally. Chart 4 plots a short-term term view of the SOX/OSX ratio. The ratio is showing tentative signs of turning up. It's broken a four-month down trendline. And its RSI line is starting to rebound. A move above its 50-day average would be an even more encouraging sign that chips are starting to do better than oil. That would be a positive turn for the entire market.

Chart 3

Chart 4