Are Crude Oil Prices Still Driving the Market?

Are Crude Oil Prices Still Driving the Market?

The Trader's U E-Letter: Issue #157

Wednesday, October 19, 2005

Are Crude Oil Prices Still Driving the Market?

by D.R. Barton, Jr., Chairman, Trader's U

Everyone is looking for easy-to-understand "cause and effect" reasons for why the market does what it does.

"Everyone" includes the media, who want to give a simple "here's why the Dow closed up/down xx points today" explanation.

But "everyone" also includes all of us traders and investors who would like to find that one indicator to watch, which will tell us the direction the market is heading.

Over the spring and summer of this year, many analysts and traders looked to crude oil prices to provide almost daily input into market direction. Some top technical analysts that I respect would often say things like, "The technical analysis tells us that we should expect a strong move up in the stock indexes today. But if crude surges, all bets are off."

Lots of folks, including me, watched our charts with one eye on crude oil almost all the time.

The big question is this: Does this inverse relationship between crude oil prices and stock index prices still hold true?

"It's a little like wrestling a gorilla. You don't quit when you're tired - you quit when the gorilla is tired." - Robert Strauss

The 800-Pound Gorilla

During the spring and summer of this year, crude oil was the 800-pound gorilla.

When crude prices moved, the rest of the financial markets reacted. A jump in crude oil prices meant a nasty day for the stock markets. And a drop in crude almost invariably brought a relief rally in stocks.

Conventional wisdom explained this phenomenon as an economic one. Since our economy is oil-based, more expensive oil means a more expensive cost basis for almost everything else. (The economy is oil-based, in that oil and natural gas are the energy sources for most processes, including transportation and electricity. Petroleum is a raw material for many chemical products as well.)

An equally plausible explanation (especially for short-term swings) is that the stock market's reaction to oil price movements are fear-based. Increasing oil prices - especially outside of historic norms - could signal structural changes in the international economic landscape. This uncertainty caused markets to worry about every additional move up in oil prices, and breathe a sigh of relief with every drop.

But regardless of the reason, we can say with certainty that during the spring and summer, crude oil prices had a distinct impact on stock price movement on a day-to-day basis.

Is that still the case?

In a word: no.

The Gorilla Has Finally Grown Tired

The price of crude oil is no longer the main mitigating factor in the work of top stock market technical analysts. This is because day-to-day moves (or intraday moves) of crude oil are no longer pushing stock prices around.

Or, building on the quote from Robert Strauss from above, the gorilla that the stock market was wrestling has finally grown tired.

But let's look at some more factual evidence. Here's a chart that shows the simple ratio of the S&P 500 to the price of crude oil.

cured oil vs S&P500

You can clearly see the ratio has contracted, and given that crude oil prices have gone up considerably over the last year, this is no surprise. But a strange thing has happened since Hurricane Katrina: The volatility of this ratio has had six weeks of major contraction.

One reason is that crude oil prices haven't moved around that much since the days following Katrina. But the more significant reason is that crude oil prices and stock prices aren't linked by the inverse relationship we talked about earlier.

So what does this mean for traders and investors? First of all, short-term players don't have to watch and react to every short-term squiggle in crude oil pricing.

Second, and most importantly, volatility contractions typically end in a burst of high volatility before reverting to a more normal state. This means that a big move in oil prices (either up or down) will likely cause a short-term inverse reaction in the stock market, as fear and/or relief enter the market again.

The bottom line is this: Oil prices are not currently pushing stock prices around like they did early in the year. But when oil prices make their next big move (above $70 or below $60), watch out for short-term ramifications in the stock market.

The Chart of the Week

Adobe systems (NASDAQ: ADBE)

Adobe Systems (Nasdaq: ADBE) is making an intermediate-term double top with a divergent MACD, as discussed in last week's TU #156 - Technical Indicator: Here's One That Just Plain Works: MACD Divergence. While intermediate levels seem to generate signals that aren't as strong as longer-term tops and bottoms, let's see how this plays out over the next few weeks.

Great trading,

D.R.

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