Will Oil Make Stocks Too Slippery to Hold?

Will Oil Make Stocks Too Slippery to Hold?

Dear Slingshot Trader Traders,

The big fear of high oil prices leading to a stock market decline is historically justified, however, the timing of such a decline can be much more difficult. Since the 4th quarter of 2011, oil prices have been rising on a combination of global risks (Iran) and expectations that demand will rise with growth. That rise has been good for the energy stock sector but if oil continues to rise, a decline in stock prices may become a self-fulfilling prophecy.

Should investors be more afraid of higher or lower oil prices?

Yesterday, the U.S. government floated the idea that oil could be released from the strategic reserve. That announcement had an immediate impact on oil prices, but it might have had a larger impact on stock prices overall. The same thing happened the last time strategic reserves were used to drive prices lower last year.

The politics of these decisions are beyond the scope of this update, but it seems reasonable to assume that if the government (who theoretically has information we don’t have) thinks the economy needs a boost, then there may be some bad news on the horizon. This is the end of the quarter, when sellers may have an extra incentive to do a little rebalancing or profit-taking on even a hint that bad news could be coming down the pipeline.

Keep in mind that oil prices will rise naturally with stock prices, because both are affected by growth and positive expectations. However, right now oil prices are double or triple the levels seen during the last bull market. Even when adjusted for inflation, prices are very high. Historically speaking, spiking oil prices and an inverted yield curve are very highly correlated with market declines and even recessions. Since we can’t observe a ‘natural’ yield curve right now, traders will hyper-focus on the information we can observe like energy prices.

Following a price spike in oil, the trend will sometimes flatten and start to diverge from stocks. That tells us that energy investors may be pricing in the potential for bad news and lower growth. Divergences in highly correlated markets like this tend to reconcile in the short term. Although it is certainly possible for oil prices to catch up with stocks, it has more often been the other way around. In the next chart you can see how prices diverged at basically this same price level (in oil) last year before the big head and shoulders pattern formed in stocks.

chart1
Oil futures (Candles) vs. S&P 500 (Black line): Chart courtesy of MetaStock Pro

 

Does a divergence mean a crash is likely?

Not all divergences lead to a big move like the one last year. In fact, more often than not, the adjustment in equity prices is negative but brief. As short-term investors, these small adjustments present opportunities and complications for us. Because a breakout to the downside is difficult to time and can be over very quickly, we focus on news events in the short term that may act as a catalyst for a short (or long term) decline. We include commentary about these new events in each trade-alert we send.

Oil inventories seem to be leading the market and our trades

New data released today showed that oil inventories or “stockpiles” increased an unexpected 7.1 million barrels. This was triple the expected increase, and stocks took a dive on the news, with the Dow dropping more than 100 points within a few minutes. This is bad news, because it indicates that demand is drifting lower. Imagine that you are a store owner, and your inventory is building up each week rather than falling – sales are probably dropping in that situation, which would not be good news. The last few times we have had a big surprise like this, the market dropped for a few days.

How we are planning to use these data

We think it is safe to say that short- and long-term stock/option traders prefer a bullish market to one that is bearish, but we can still use this news to our advantage. Right now, there are a number of companies that have been rising on very weak fundamental data as the broad market has rallied. Earnings season kicks off again in a few weeks, and a number of these firms are setting up to disappoint their shareholders. We can target these firms, like we did Jos A. Bank (JOSB) this week, to take advantage of the potential for a big adjustment.

This Week’s Events

This is a very light week but here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

Mar. 29 – Final quarterly GDP

Apr. 2 – ISM Manufacturing PMI

Apr. 3 – FOMC Minutes

Apr. 4 – ADP Employment data

Apr. 4 – Monsanto (MON) quarterly earnings

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here.

Open Positions

These are the SlingShot Trader positions we opened during the past two weeks of trading that we have not yet closed.

iShares 20+ Treasury Bond Fund (TLT) – On March 14 we recommended you to “buy to open” the April 111 puts for $2.00 or less. We still like this trade and recommend entries at our maximum price or less.

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Jos Banks (JOSB) — On March 28, we recommended you “sell to close” the April 55 puts. We closed the position for $4.45 for a gain of 102.27%.

Silver Wheaton (SLW) — On March 23, we recommended you “sell to close” the April 32 Puts. We closed the position for $0.80 for a loss of 24%.

ConAgra Foods (CAG) — On March 22, we recommended you “sell to close” the April 26 calls. We closed the position for $.46 for a loss of 38%.

Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com.

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader