OCTOBER TOP IN OIL IS NORMAL -- FALLING CRUDE IS FUELING FOURTH QUARTER MARKET RALLY -- WHY $40 SHOULD BE NEW FLOOR UNDER CRUDE OIL
OCTOBER TOP IS NORMAL... Since the direction of crude oil is so important to the stock market, and because I've received so many questions on the energy sector this week, I'd like to spend more time on the subject. Before doing so, however, I'd like to review an update posted in late September which puts the current situation in a longer-term perspective (September 23, 2004). The headline read: OIL MAY BE CLOSE TO AN OCTOBER TOP -- BUT $40 MAY BE NEW FLOOR -- OIL STOCKS ARE OVERBOUGHT BUT IN SOLID UPTRENDS. The first paragraph from September 23 (History of October Tops) pointed out that crude oil had peaked in nine out of the last twelve Octobers. It also suggested that "a drop in oil might give a boost to the stock market, which has a history of forming October bottoms". It also suggested that any fourth quarter decline in crude wouldn't drop under $40 which was the new floor under the oil market. The next chart shows where that number came from.
Chart 1
WHY A $40 FLOOR IN OIL ... The monthly bars in Chart 1 are similar to the ones plotted back in September, and show the crude oil trend since 1990 at the time of the Persian Gulf War. It shows that $40 had been a major ceiling over the oil market from 1990 to 2003 (see circles). Interestingly, both peaks at $40 occurred in the months leading up to the two Iraq wars. Although it's not shown here, oil also peaked at $40 in 1980 which ended the inflationary spiral of the 1970's. Earlier this year, crude broke through the historic barrier at $40 and climbed to $55 before peaking in October. In chart work, previous resistance peaks are supposed to become new support levels. That's where the $40 floor comes in. Since $40 represented a resistance barrier for more than twenty years, it should now function as a support level on intermediate corrections. The weekly bars in Chart 2 also show why $40 is a logical support point. Not only is it the peak formed near the start of 2003 (see circle), but also meets a rising support line extending back to October 2003.
Chart 2
WHAT ABOUT OIL STOCKS... I also wrote on September 23 that "an October pullback in oil could cause some profit-taking in oil stocks" but that "a decline near $40 would, in my view, represent another buying opportunity for oil/or oil stocks". We've gotten some profit-taking in energy stocks since then. Only time will tell if buying near $40 is a good idea. For the present, let's look at the two main energy ETFs. Chart 3 shows the Energy Select Sector SPDR (XLE) bouncing off its 50-day average. One of the rules I recommend is to use a close under a 50-day line as a sell signal. Although the line has held so far, I'm skeptical about how long a bounce will last given the heavy downside volume this week. That being the case, I think a prudent move would be to "lighten up" on any bounce from here. In other words, sell some portion of any long position that is being held. A close under the 50-day line would justify more selling. Chart 4 is a point & figure chart of the XLE. Although the XLE has reversed into the o (down) column, it would have to fall to 34 to issue a major sell signal. That would coincide with a violation of the early November low on the daily bar chart. Even longer-term investors might want to do some selling if that low is broken.
Chart 3
Chart 4
OIL SERVICE ETF BREAKS 50-DAY LINE... The daily bars in Chart 5 show the Oil Service Holders (OIH) closing under their 50-day line yesterday on heavy volume. In my opinion, that in itself is justification to do some selling -- preferably on a bounce. As I suggested earlier in the week, I believe the OIH will eventually retest its early November low which will be a more crucial test of the major uptrend. Chart 6 is a point & figure chart of the OIH. The down column of o's is the biggest on the chart, which suggests a weakening of the trend. To date, however, no actual p&f sell signal has been given. Point & figure sell signals would take place on prices drops to 79.00, 77.50, and most importantly to 76.50.
Chart 5
Chart 6
LONGER-TERM IMPLICATIONS FOR STOCKS ... The last paragraph in the September 23 report carried the headline: LONG TERM IMPLICATIONS FOR STOCKS AREN'T GOOD. To repeat what I wrote then, "An October pullback in oil would probably be helpful to the stock market during the fourth quarter. The ability of oil to stay over $40, however, will remain a drag on the stock market and the economy...and will probably limit stock market gains during 2005". So far, the October top in oil (and this week's downturn) has been bullish for stocks and fits into the idea of a fourth quarter rally lasting into the start of next year. The longer-term picture is still in doubt. If this is just an intermediate correction in oil, and if oil starts to rise again next year from $40 (as I suspect it will), the stock market could run into trouble. That's another reason why $40 crude is such an important number. In case you're wondering if oil really has an impact on stocks, take a look at the last two charts. The peak in oil during March 2003 (at the start of the second Iraq war) coincided exactly with a major bottom in the S&P 500 (see first arrow). The second peak in oil this October (see second arrow) helped launch the latest S&P 500 upleg. Right now, the drop in oil is working in the stock market's favor.
Chart 7
Chart 8
