Why Oil Is Signaling That S&P 500 Resistance At 1220 May Hold

Includes: CAT, DIA, FXE, SPY, USO, UUP
by: The Independent Investor

It is Interesting as a trader to try and find correlations between indexes and asset classes in an uncertain and volatile market. Obviously, while no correlation is perfect, strong links between asset classes often are powerful indicators of potential moves in the market. One correlation I've watched over the last couple months that has been particularly strong has been the nearly identical moves in oil (WTI Contract) and the S&P 500 over the last couple weeks. Oil bottomed at around 77 dollars a barrel in overnight trading a couple of weeks ago prior to the market holding the 1100 level, with oil subsequently moving from 77 to around the 90 dollar level while the market moved from 1100 to just over 1200. Despite this recent move up in oil, the commodity has now repeatedly failed at the 90 dollar level, unable to break this resistance point even on days when the market and the Euro were significantly higher.

I think the move in oil is a good indicator of the future direction of the market for several reasons. First, oil is tied to economic growth and is also easier for traders to move higher since you only need 20% collateral to trade WTI futures in a portfolio margin account. Second, oil is highly correlated to the Euro-Dollar cross since it is denominated in dollars and roughly 60% of the dollar index, so the move in the commodity often parallels events and fears coming out of the Eurozone as well.

What was very interesting is that while oil and the S&P 500 are now beginning to test key resistance points at the 1200 level for the equity markets and 90 for oil, the recent price action in oil is suggesting that a next leg up my be difficult. The fact that on Wednesday oil failed for the third time to break and hold the 90 dollar level on a day when the market was up nearly 200 points and the Euro was rallying for the third straight day is important. Certainly, no correlation is perfect and oil's drop over the last couple months was much more severe than that of the Euro and the S&P 500. Still, it's worth asking why oil couldn't break and hold the 90 dollar level on a day when the market and the Euro made big moves higher and oil had opened the day over the 90 dollar level.

As I've written in recent articles, I don't think the market is likely to fall significantly from here because of the relative valuation of stocks to most safe heaven assets such as bonds. However, I do think a break of 1100 is likely going to occur since the recent rallies in the market over the last couple weeks have failed to break the 1200 level, and the market seems to have trouble attracting real and sustainable buying. I'm also highly skeptical of this rally for several reasons. First, these ridiculous rumors of China and other emerging market countries buying significant amounts of Italian and other European nation's bonds seem largely baseless to me. Many, if not most, of these bonds are junk and the idea that astute foreign buyers would plow money into these risky assets is not a credible suggestion. China also recently came out and clarified that though they have had conversations with Italian authorities, they are looking at investing in Europe in specific places at the right price and with conditions. It's also likely that even if China were to purchase a certain amount of bonds of the PIGS nations they wouldn't be buying on anywhere near the scale necessary to change the underlying dynamic in the Eurozone.

The second reason I'm skeptical of this recent move is that the financials have not taken part in the move up. While financials have often lagged the market, European and American Banking stocks were at the center of the recent sell-off, and I think it is likely they would need to at least stabilize before we get a real move higher. Also, JP Morgan's (NYSE:JPM) recent warning about weakness in the investment banking division and Bank of America's (NYSE:BAC) new plans to fire more than originally planed suggest the financial sector could see some continued weakness. The JPM warning and recent announcements by banks like Citi (NYSE:C) to raise fees on checking accounts suggest further head count reductions could occur in this sector as profits lag the rising costs these companies face from new regulations.

Third, given that the news in Europe has not improved over the past couple weeks and none of the recently released economic data points on consumer spending and manufacturing were positive, it's worth asking why the market has held up so well. I am not a conspiracy theorist and I do believe that over the long-term markets will be priced based on earnings and growth projections. However, in the short-term, it's a fairly safe assumption to think that market manipulation can move asset prices for a while. It is also interesting to me that the negative overnight news on European Banks needing emergency credit lines that came out Wednesday morning didn't cause anyone to knock the futures down hard. Many of the rumors that are now coming out seem to be attempting to move or at least stabilize the Euro, and this suggests to me that there are some larger net longs which obviously want to move the market higher.

To conclude, there is a credible case to be made that the market is oversold. Still, given that Europe has been moving the market and no new positive news came out of this continent and the data points on the U.S. economy have been mildly disappointing at best, I am skeptical. With the market in a vulnerable spot I think it is highly unlikely that we will get a sustainable rally without the financials taking part or any new and substantive developments coming out of Europe.

Disclosure: I am short USO.

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