Play Oil for an Upside Bounce

When we consider indicators, markets or stocks that are emblematic of the market, the most obvious marker - and an area that has been in focus for some time - is oil prices. With worldwide growth playing a more significant role as emerging markets flourish, oil consumption has risen, making oil the leading economic indicator.

Stock prices and oil prices have become highly correlated, with one incapable of moving in any direction without the other following. When oil demand remained strong, so did worldwide economies. However, with the recent collapse of worldwide economies, oil prices have sagged as well.

This simply tells us that the main concern for stocks right now is the economy, and the market anticipates the weakness is not over. We acknowledge the possibility that some of the magnitude of the decline is due to deleveraging and hedgefund liquidation, but that does not change our point that the direction is what is important. That direction is down because demand continues to weaken and markets are pricing in further weakness. The question now is how much more will be priced in, or has what needs to be priced in occurred already?

Let's focus on the latter choice and look for a short-term rally to occur. In this market, most conventional analytical measures have become less effective due to deleveraging. That in turn means being creative and accepting more risk when trying to find trading opportunities.

The price of crude oil has fallen almost 66% from July highs, and it seems that we have overreached to some degree on this decline. This level of retracement is significant, as typically we see support surface during declines at either the 50% or 66% retracement level. Yes, the hedge funds have liquidated, and yes, the economy seems to have shut down overnight, so the drop may be logical. That does not preclude a recovery rally, however, as the selling pressure dries up. Also, if we believe we will get some recovery in stock prices, we should expect some recovery in oil prices as well (based on the positive correlation between these two markets).

United States Oil Fund

Click here for larger image.

Using the United States Oil Fund (USO - commentary - Cramer's Take) as a proxy for oil prices, we would consider looking to get long at current levels for a rally back toward $60. That would simply represent a minor recovery, but would prove to be a profitable trading opportunity. As far as a stop, we can pick two places. For those with a quick trigger finger, use a move below $38. If you're looking to give the idea a bit more time to work itself out, we would suggest the $36 level.

---

Know what you own: Because the United States Oil Fund tracks the price of oil, some related equities investors might be interested in include: ExxonMobil (XOM - commentary - Cramer's Take), Chevron (CVX - commentary - Cramer's Take), Royal Dutch Shell (RDS-B - commentary - Cramer's Take), BP (BP - commentary - Cramer's Take), PetroChina (PTR - commentary - Cramer's Take) and Total SA (TOT - commentary - Cramer's Take). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

---

At the time of publication, John Hughes and Scott Maragioglio had no position in the stocks mentioned. Hughes and Maragioglio cofounded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.