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By David Silver

 there is some new projection about how high oil prices are going to go or how the U.S. economy is slipping deeper into a recession; some have even begun comparing the current state of the economy to the Great Depression. This article will show the hopeful silver lining to that cloud over Wall Street.

Crude Oil: Oil prices are up about 85% year over year and the main reasons being cited are the supply/demand discrepancy, the weaker dollar, political unrest, and the fact that emerging economies are drastically increasing their demand. We will look at each factor individually, but we do realize that each affects the others as well.

Let's address the supply/demand issue first. Yes, emerging economies such as China, Russia, India, and the Middle East are using more oil than five, ten, and fifteen years ago, but are they using 80% more? Additionally, experts say that all the "easy oil" has been found, but oil is still bubbling to the surface in the Kurdish region. Brazil recently found an oil reserve off its coast that could potentially hold 33.0 billion (yes with a "B") barrels of the black stuff and would be the world's third largest oil reserve. Additionally, this reserve would surpass the 21.8 billion barrels of proven reserves that the U.S. currently has at its disposal. Surely, a find such as this would improve the perception of the supply end of the formula. As oil prices have spiked above $130 and then $140 per barrel, governments across the world, which had been offering subsidies to their populations and refiners, have begun to lessen those subsidies, which should prove to slow the increase in demand. China's oil subsidies were cut by 18% in June, which some say isn't enough, but if oil prices jumped 18% overnight, there would surely be a large backlash (not to mention a Congressional "investigation"), and a subsequent drop in demand.

To me, it looks like the bubble has moved from tech stocks at the early part of this century, to the housing market, and now onto commodities. Will oil see as dramatic of a drop as the tech sector did following its historic collapse, or as the housing market is in the midst of seeing, or even as the correction following the oil crisis of the late 1970s? My answer is probably not, but even $100 or $90 for a barrel of oil would be welcomed with open arms and a bottle of champagne.

click to enlarge

Next we will look at the weaker dollar. The dollar has been declining compared to the Euro for the better part of the last two years and oil, as the two-year chart above shows, has seen a drastic change since August of 2007. The following chart shows how many greenbacks one Euro would purchase.

While the charts are similar, the abrupt increase that we see in the oil chart is not present. For days, as oil spiked and the dollar weakened, talking heads on television said the rise in oil was a result of the weakening dollar. However, it appears that the tail is now wagging the dog, as the dollar has reacted to the price of oil instead of the other way around. Economists say the weaker dollar has caused oil to rise, and that the price inflation is affecting the strength of the U.S. economy (and the world for that matter), and possibly leading to recession. Denmark is officially in a recession and Spain, Italy, and the United Kingdom are flirting with the dreaded "R" word. When thinking about the weaker dollar relative to oil prices and inflation, it would stand to reason that as economic growth around the world begins to feel the pressure from inflation oil prices would move lower. However that has not been the case as a slower U.S. economy has led to a weaker dollar which has pushed oil prices higher and thus an even weaker U.S. economy; and the cycle continues.

Finally, we have political unrest. There is always some sort of rhetoric being pushed around that sends oil prices higher, whether it is Iran firing test missiles, talk about an inevitable invasion of Iran, anti-American talk from Venezuela's Chavez, or terrorist (sorry, rebel) attacks on pipelines in Nigeria. Some sort of political unrest premium is being worked into the price of oil, but has anyone realized that the political unrest even in times of relative calm rarely comes out of the price? It only adds upon the last scare. It's really not a question of if, but when for all these cataclysmic events to occur.

State of the Economy: The doomsday predictions about the state of the economy have taken a back seat lately to $200 oil and $7.00 gasoline, but the undertones are still there. As we enter this next round of earnings releases it will be interesting to see how the market reacts to those multinationals that continue to perform well. For instance, take the railroad industry; higher fuel costs and a slowing economy were expected to eat into volumes and pricing power, but that has not been the case. Exports have continued to drive the sector, with coal and grains leading the way. Despite a continued slowdown in the housing market and drastically fewer shipments of automobiles, total carloads are higher year over year with ton-miles up 1.5% year to date. The economy has yet to "officially" slip into a recession, but everyone from Wall Street to Main Street is feeling a pinch.

Yesterday morning, Wal-Mart (NYSE:WMT) reported better than expected results for its sales during the month of June and raised its earnings estimates for the second quarter. Pundits will say it was a stimulus-check-induced bounce, but the strength at other retailers such as TJ Maxx (NYSE:TJX) and Ross Stores (NASDAQ:ROST) show that Americans, despite higher fuel and food costs, were still spending money, even before the checks arrived. Perhaps the biggest highlight from Wal-Mart's June sales figures was the jump in the home category, which had been languishing for the better part of two years.

All in all, despite officially entering into bear market territory, Americans aren't crying uncle. However, the real lynchpin for this market to turn around (and economy for that matter) is the financials. Rumors of additional write-offs and insolvency are the name of the game, and until the financials can shore up their balance sheets and right the ship, it won't matter how well the other sectors do as the market will continue to have the weight of the financial world on its shoulders.

Call me a bull, call me optimistic, call me whatever you would like, but I don't think the economy is as bad as the media is making it out to be. Yes, Americans are having to change their habits, yes there are rumors every day about another company on the edge of bankruptcy, but the fact remains that the unemployment rate is at 5.5%, and until a few years back, that was considered full employment. Which brings us back to the financials; if the CEOs of JP Morgan (NYSE:JPM), Jamie Dimon, Bank of America (NYSE:BAC), Ken Lewis, Citigroup (NYSE:C), Vikram Pandit, and Lehman Brothers (LEH), Richard Fuld, can get their respective acts together and begin to change public opinion, then the rest of the economy will fall into place like dominoes.

Written by David Silver, a Research Analyst for Wall Street Strategies (www.wstreet.com) covering companies in the Transports, Autos, and Beverage sectors.

Disclosure: none

Source: Getting Out of Today's Bear Market