Oil’s Affect On Consumers: Look At These Numbers

• July 1, 2005
• Mark Boucher

Balancing
Act Among Bonds, Oil, and the Dollar Continues

We have been advising caution
in the market since the end of 2004 not because we expected a huge decline, but
because we expected a frustrating trading range environment.  So far that
scenario continues in what we have called the “meat-grinder” market.  

Oil moving above $60 was the
first knife in the back of the intermediate-term bull move that started in
March.  The Fed may have given us the second knife today with no change in
rhetoric at all and an expectation for continued rate hikes at a time when the
market was expecting an end to hikes soon. 

For those brave souls who want
to trade in this treacherous environment, we suggest watching bonds, oil, and
the dollar carefully for clues as to the markets likely upcoming direction.

While the dollar is overbought
and sentiment is at an extreme, the one clear fundamental pushing up the dollar
has been the propensity for the Fed to keep hiking rates at a time when most
other global central banks are considering rate cuts.  Many Asian countries have
already started easing.  Many Latin countries appear on the verge of cutting
rates.  Even the UK and ECB may now be considering rate cuts.   Polarization of
interest rate policy may continue to exert pressure on currency markets.  Yet
another advance to new highs in the dollar from here could start to become a
negative for the market, similar to its reaction of crude oil above $60.  A
stronger dollar in reaction to the Fed’s unchanging penchant for raising
short-rates would be deflationary, would widen the trade deficit, and would
start to negatively impact global growth.  At the same time, sentiment is at an
extreme and the EUR is hitting a major support level in the 1.17-1.20 zone. 
Investors need to watch the dollar carefully for clues as to what impact it will
have upon the market.

We’ve already gotten a glimpse
of what oil prices over $60 will do to the market with last week’s action.  Oil
has reversed fairly strongly this week, but not enough to boost the market. 
Further strong declines will allow the market to breath clear air, while any
approaches of $60 will likely again become an immediate drag on prices.  The
declines from $60+ oil are not however likely to be massive — in real prices oil
needs to get to over $100 a barrel to match the prices of the ‘70’s in
after-inflation terms.  As a percentage of personal disposable income, energy
costs rose from 5.5% to 7.2% during the mid ’70’s oil shock and then from 6.3%
to around 8.3% during the late ‘70’s oil shock.  Currently energy prices have
risen from 4% to 5.5% – a similar magnitude of gain, but probably having less an
effect because consumers are still spending less on oil than they did all during
the seventies and more than half of the 80’s.

The main stabilizer preventing
Fed rate hikes and oil price spikes from killing the global economy has been
consistently lower global bond rates.   Bonds in Asia and Europe are making
all-time highs, while bonds in the US are being dragged higher as well. 
Investors should remember that as long as bond prices are near their highs, the
downside in the market is likely to be limited.

We therefore advise investors
to watch these critical markets as well as volume and breadth figures to try and
ascertain the market’s next direction.  But realize that bullish and bearish
forces are somewhat stalemated in this environment and odds of strong movement
in either direction doesn’t appear that high based on historical analogies. 
Investors should stand mostly aside and leave trying to traverse this balancing
act to more aggressive and drawdown insensitive short-term traders.

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 66, 26, 50, 74, and 86 with 21 breakouts of 4+ week ranges, no
valid trades and one close call in AIB.  This week, our bottom RS/EPS New Lows
recorded readings of 8, 14, 19, 4, and 7 with 6 breakdowns of 4+ week ranges,
one valid trade in UIS and no close calls.  One valid signal remains in place in
LCAV on the long side and in IDT and now UIS on the short side.    After last
week’s fireworks we’re back to a more defensive posture both with official
trades and with suggested actions. 

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training  module.
Basically, we have rigorous criteria for potential long stocks that we call
“up-fuel,” as well as rigorous criteria for potential short stocks that we call
“down-fuel.” Each day we review the list of new highs on our “Top RS and EPS New
High List” published on TradingMarkets.com for breakouts of four-week or longer
flags, or of valid cup-and-handles of more than four weeks. Buy trades are taken
only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts
are similarly taken only in stocks meeting our down-fuel criteria that have
valid breakdowns of four-plus-week flags or cup and handles on the downside. In
the U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

The market will have to give strong clues as to whether the retest rally is over
and a broad trading range is established or whether this market can recover from
this setback — oil, bonds, and the dollar likely hold the key and right the
dollar is still rallying as is oil, offsetting some of the cushion provided by
rallying bonds. 

Mark Boucher