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Short-Term Update – On Oil and the Dow Theory

(October 6, 2004)

Please note that the 100% long position initiated on August 19th was stopped out on September 27th at our entry point.  The author is seriously thinking of going 25% short the Dow Jones Industrials sometime in the next few trading days.  Stay tuned - I will post a message on our "Special Alert" discussion forum once we have established a position.

Great news: Mr. John Mauldin of www.frontlinethoughts.com is coming to Houston the coming weekend and I have confirmed my meeting with him.  As you may know, I am planning to conduct an "interview" with him on a one-on-one basis and will post my questions and his answers on this website as soon as we can.  Again, I have always admired and respected his work a lot and I am very excited to be able to meet him in person.

Dear Subscribers and Readers:

Dear readers, please note that this will be another short-term update on the market.  I feel this is perfectly appropriate given the confusing times that I bet a lot of my readers are experiencing right now.  The question remains: Can the market hold up in light of an all-time high in oil prices - an inflation-adjusted oil price not seen since the first Gulf War?  Is the market discounting a lower oil price down the road (if you think that this is the case, I would like to point out that March 2005 contract is selling at $49.54 and the June 2005 contract at $47.30 as I am typing this - obviously, the crude oil traders don't agree with you)?  Or is the Dow Jones Transportation Average (besides energy, basic materials, and casino stocks) the last major index holding up the market - whose components are passing on their costs at the huge expense of their customers - including components of the Dow Industrials and biggest companies in the S&P 500?  Before I go further, let's take a look at the history of the NYMEX oil contract in inflation-adjusted dollars.  Following is today's chart from www.chartoftheday.com:

Oil prices are nearing 20-year highs but are still significantly lower than the inflation -adjusted record highs of 1980.

This chart does not outline the action of the market coincident with a spike in oil prices, but it does indicate to us that most oil price spikes have been accompanied or followed by an economic recession (recessionary periods are highlighted in gray).  In inflation-adjusted terms, the current price spike in oil is the most significant since the period leading up to the first Gulf War.  Can one reasonably (or heaven forbid, logically?) expect the market to be indifferent to this spike?  It is interesting to note that the American Exchange Oil Index (the XOI) made another all-time today.  This author thinks that at the least, we should expect a correction here.

The NYMEX November contract for crude oil closed at $52.02 today - an all-time high - due to a combination of factors such as potential supply disruptions (Nigeria, YUKOS, Iraq, and so forth), the low supply coming from the Gulf (off of Texas and Louisiana), low inventories, and more importantly, the lack of spare pumping capacity around the world.  The author's educated guess is that something has to give here, and given that it takes months if not years to increase spare capacity, my guess is that the economy and the stock market will have to give until we will see a sustained cooling down in crude (and natural gas) prices.  Like I said before, the success of the transportation companies (ex airlines) passing on their fuel costs is coming at the huge expense of their customers - said customers being components of the Dow Jones Industrials and the biggest companies on the S&P 500.  This trend cannot go on - at some point, once their customers or the American consumers are tapped out, that will also mean disaster for the transportation companies.

Let's take a look at how the Dow Jones Industrials performed during the last two major spikes in oil prices - I am now going to present a two-year chart for the 1989 to 1990 and the 1999 to 2000 period:

Spot Prices of Crude Oil vs. DJIA (January 1989 to December 1990)

Spot Prices of Crude Oil vs. DJIA (January 1999 to December 2000)

Please note that action of the Dow Industrials during the period leading up to the invasion of Iraq and the subsequent price spike in crude oil.  The DJIA declined from a peak of nearly 3,000 to 2,365 (21%) in just a little under three months.  Also, please note that while the percentage increase of the current spike is nowhere near as steep as the increase during the July to October period, the oil price today is sitting at a level comparable to the top of that price spike in inflation-adjusted terms.

The second chart depicts the steady increase in oil prices vs. the Dow Jones Industrials during the 1999 to 2000 period.  Sure, the tech bubble burst in March 2000, but this increase in oil prices (along with the huge natural gas spike during the winter of 2000/2001) probably played a part in the underperformance of the market for the next nine months as well (up until the events of September 11th).  Given these historical precedents, can one reasonably expect the market to escape unscathed from this latest spike in crude oil prices (please note that it is not just about oil prices, but natural gas prices has recently increase quite a bit as well)?  This current action of the Dow Transports and oil prices concurrently making new highs is something that we have not seen since the relentless rise of the Dow Transports during 1980 (concurrent with the Iranian Crisis and the largest oil spike in history).  Of course, the 1980 rise ended badly, but who's to say that the Dow Transports cannot continue to go up from here concurrent with continued increases in the oil price?  The author is not going to discount this scenario, but one thing this author is sure about is this: Even if the Dow Transports can continue to go up from here despite more highs in oil prices, I doubt that the Dow Industrials can hold its own going forward (this is a major reason why I am contemplating of going short the Dow Industrials in our DJIA Trading System).

Turning to sentiment indicators: The Investors Intelligence Bulls-Bears% Differential increased from 28.1% to 28.4% during the week.  Sounds bearish from a contrarian standpoint?  Well, think again: The AAII Bulls-Bears% Differential now only stands at 2% -- the lowest since mid-August and bullish from a contrarian standpoint.  A divergence in these two surveys is rare, and this author cannot help but think that most traders and investors out there are now very confused.

The following Rydex Cash Flow Ratio chart has just been updated by Decisionpoint.com.  Well, at least this indicator is somewhat confirming my current bearish view, as the ratio is now at a level past the most recent peak:

Rydex Cash Flow Ratio

Nonetheless, these are confusing times.  The Nasdaq has just turned in seven consecutive days of positive action and both the Nasdaq and the S&P 500 are now very overbought.  Lowry's is still bullish, although Richard Russell maintains his bearish stance - despite the non-confirmation of his bearish stance by his technical indicators.  In terms of great confusion, I always like to turn to the Dow Theory.  So what is the Dow Theory saying now?  Let's turn to the following chart to get a clearer view:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to October 6, 2004) The Dow Transports made another 5-year high today even as crude oil prices made another all-time high. The author's guess is that the upside action of the Transports is occurring at the expense of the Industrials - as the companies in the Industrials and the S&P 500 are forced to 'eat' this extra fuel costs because of the lack of ability to pass them on to American consumers. The Dow Industrials is again meeting resistance at its downtrend line dating back to February earlier this year. The author does not believe the Dow Industrials can break that uptrend line, but stranger things have happened.

The lack of ability on the Dow Jones Industrials to penetrate its downtrend line going back to February earlier this year smells of distribution.  The current upside non-confirmation of the Dow Transports by the Dow Industrials is the most flagrant non-confirmation in Dow Theory history ever since the 4-year non-confirmation of the Dow Industrials by the Dow Jones Rails during the 1933 to 1937 rally.  The author maintains the stance that the Dow Industrials would not be able to penetrate this uptrend line before we have a significant correction - for all the reasons I have mentioned above.

Bottom line: This author believes we will need a significant correction at least in the Dow Jones Industrials before we can mount another sustainable rally.  This author is also seriously thinking of implementing a 25% short position in our DJIA trading system in the next few trading days.  Readers please stay tuned.

Signing off,

Henry K. To, CFA

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