Falling Oil Sets Trap
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Having mulled over a variety of possible outcomes with oil and its impact on equity markets, I cannot shake one troubling scenario that I call the "oil trap." It keeps coming up as I consider various crude price moves. What is so dastardly about the trap is that it sets up both bulls and bears for heartache.
Unfortunately, I consider it a very high-possibility scenario.
How the Trap Got Set
As someone who has been bullish on oil since December 2003 -- and mentioned a $57 target
here in late-September 2004 -- my expectations have been met, even exceeded. I am now comfortable stating my expectations of an intermediate-term oil top between $57 and $59; Tuesday afternoon, crude was recently down $1.46 cents at $56 per barrel.
I expect the stock market's response to a pullback from these levels to be positive, but short-lived.
Consider the course oil took to reach these levels over the past two years -- it's almost, but not quite, funny. Oil bears -- the ones who were so negative when crude was between $40 and $45 -- have suddenly found religion. I recall hearing repeatedly about a $20 "terror premium" built into crude, and that there was a $15 bump caused by the speculators. I even recall hearing that the Chinese economy was about to nose-dive, thereby implying a dramatically reduced demand for oil.
Indeed, I have heard every "excuse" for the price of oil being what it is -- except for the one that matters: a gradually improving global economy, with expansion concentrated in Asia, particularly in China and India.
But when oil passed $50 on the way to $55, an intriguing sentiment shift occurred: The oil bears suddenly became rip-roaring bulls. That is a small part of the reason I suspect we are now entering what academics refer to as "the stupid phase." We hear calls for $80 and $100 crude, and note that firms such as
ExxonMobil
(XOM) - Get Report
gained nearly 20% last month. This amounts to an unsustainable extension of gains for the energy sector.
Oil has now become a crowded trade. Recent
Commitment of Traders data show the speculators have shifted to net long crude futures and options, as opposed to a more recent position of nearly "net flat."
Getting Caught in the Trap
Here's one way the oil trap scenario plays out: Oil makes an intermediate top in the $57-$59 area. At the same time, the sentiment measures move to extremes -- last week the equity put/call ratio climbed to over 90%, a good start. Once sentiment reaches contrarian levels, the stock market makes a short-term bottom. Oil begins to pull back off its recent highs, which encourages stocks to rally further.
When oil once again finds its footing, my guesstimate is a pullback to $48-$52 -- the rally ends but not before it has set up a potential double top in the major indices. That fake breakout pulls in a lot of bulls and some bears, too.
It is feasible (though far from definitive) that this high marks the top for equities in 2005. Regardless, as oil rallies back toward its prior highs, and possibly beyond, stocks simply run out of gas. We start heading back toward August 2004 levels, or worse.
What to Do?
I have been advising clients for several weeks now to use any lift in prices as an opportunity to reduce margin and, where appropriate, marry puts to long positions.
Why so much negativity? Recall in December when I mentioned my
bear sandwich theory. That was in part based on assumptions -- on Social Security reform, employment and interest rates -- which have since proven too optimistic.
Post-election, Social Security reform appeared to have a solid chance of passing. Regardless of your views on private accounts, the prospect of hundreds of billions of dollars of fund flow would have most certainly gotten the market's animal spirits excited -- at least temporarily. My midyear targets of 2620 for the
Nasdaq Composite
, 11,707 for the
Dow Jones Industrial Average
and 1324 for the
S&P 500
were, in large part, premised on some form of reform legislation getting passed.
There's no other way to put it: The White House dropped the ball and failed to capitalize on its election victory. It hardly got any mileage out of the surprisingly good Iraq elections. Last year, I thought private accounts had a better-than-even chance of passage; now, I doubt the proposal has a 1-in-5 chance.
As for the employment situation, even my pessimistic assumptions were surpassed -- to the downside. Despite last month's upside surprise, we are still far below where I had hoped the economy would be at this point of the economic cycle. Wages remain soft and job creation is overly reliant on Uncle Sam. Even the low unemployment rate is misleading: People who have exhausted their unemployment benefits, under-employed workers, and labor force dropouts make the unemployment rate appear much better than it actually is. It would take a string of three good payroll numbers in a row for me to revise this indicator upward.
Finally, interest rates have ticked back to where they were in the first week of 2005. Fears of appreciably higher rates continue to weigh on the markets. The risk I have repeatedly outlined is the dampening effect on the housing complex -- which remains the most robust sector of the economy. With today's seventh tightening, the
Federal Reserve
will effectively be choking off the most robust sector of the U.S. economy.
Given that my views on Social Security reform and the employment outlook have proven to be overly optimistic, I am now throttling back my midyear expectations. My new midyear targets are 11,215 for the Dow, 1255 for the S&P and (what is probably overly optimistic) 2470 for the Comp. (Note: I haven't changed my year-end targets, which remain rather bearish at 9703, 950 and 1825, respectively.)
It bears repeating: As risk increases, it is a prudent course of action to reduce margin exposure and, where appropriate, marry puts to long positions.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to
barry.ritholtz@thestreet.com.