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Bounce in Crude Oil?

The rally may not be over. Why indicators may point to a near-term rebound.

In the past month, we have seen the stock market make a two-year low, and at the same time, we've seen commodities and commodity stocks not only peak, but also collapse. The trade that worked so well for the majority of the last year, being long commodity stocks, has collapsed in less than one month. So I thought we might start by taking a look at oil, the commodity.

You can see that the September crude oil futures contract has a trend line that comes in near 110 112. There is also a previous low dating back to April that is around 110.

When looking at trend lines, one has to understand that there are different slopes. In my experience, the steeper the slope, the more likely the trend line will be broken. That's because very rarely does a market or stock rise at a high rate of acceleration and keep going. And if it continues to rise with a high rate of acceleration, it typically turns into something unsustainable which, generally speaking, we would call a blow-off. Blow-offs are not bullish!

However, when you can draw trend lines that are flatter or have a more gradual slope, they seem to be more reliable. By more reliable, I mean that I think the market more often tends to bounce from flatter trend lines. By the same token, I think breaking a steep trend line is not nearly as bearish as breaking a flatter one.Now, let's look at the weekly chart of crude oil. Here's another trend line, which gives us an opportunity to make another point about them. Traders should keep in mind these are lines, and just as you learned in geometry, two points make a line, and the third confirms it. (And you thought you didn't need to remember that sort of stuff!) Therefore, the more points on the line, the stronger the line is. On the weekly chart below, I count about five points on that line, making it a pretty good one in my view.

If you squint hard enough, you can see that the price for this trend line comes in at just over 100. Keep in mind that it's rising, and as time goes on, the price will go up. Therefore, I would begin to look for a bounce in crude oil from somewhere in the 110 area. It might go all the way down to 100, but it is my sense that it will bounce before it gets there.

How does this affect the stock market? Lately, as oil goes down, stocks generally go up and vice versa. It has not always been like that, and at some point, I expect that will change, but for now the two appear to be linked in my opinion.

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There's an intermediate-term indicator I use to determine when the market is overbought or oversold. It is the 30-day moving average of the net of the advance/decline line. As you can see in the chart below that shows the time frame 6/22/07-8/12/08 , this indicator reached its maximum oversold reading on July 15, which happened to be the exact low in the market. It's not always that perfect, but it often gets the date correct within a couple of days. I believe this indicator will reach a maximum overbought reading again on approximately August 27 because at that point, a string of very positive numbers will have dropped off the 30-day moving average.

I believe it's easier to pick lows than highs in the market. This is because it's human nature to want to buy, not sell. After all, how often do you see the Dow up 100 points on the day and think "I want to sell," rather than "What shall I buy?" In general, highs in the market tend to take more time to form than lows.

For now, I believe the market will be overbought on an intermediate-term basis around August 27, so after that period of time, I think we can begin to look for a rally in crude oil that lasts longer than just a day or two.

Given what we know about the market in general, the rate of downward acceleration we're seeing in crude does not seem sustainable to me.

The trend line in crude is very steep, which is typically more easily broken than a more gradually sloping or flatter trend line, which tends to encourage a bounce.

With stocks and oil currently trading in a negatively correlated fashion, as soon as the market becomes overbought and ready for a pullback, I think the odds of a turn in crude oil rise.