Will Rallying Oil Set a Bear Trap?

Monday, June 20, 2005 | 12:20 PM

The recent sideways consolidation has been far shallower and more contained than many traders expected. We read this as confirming our prior views that there remains a large contingency of underinvested hedge funds (and others) who are now dip buyers. We also note, however, that Mutual funds are running with bearishly low cash levels  of cash on hand. The latter could lead this consolidation lower, while the former is what could keep this retracement well contained.

More interestingly, we have been watching Oil’s rise and would like to bring to your attention a somewhat counter-intuitive potential this surge has. Namely, Crude oil making new highs (see nearby chart) creates a potential for a “Bear Trap.”

You may recall our prior discussions in March of this year, where we looked at the double top in Oil at $57 as creating likely a “Bull Trap:” As Crude temporarily pulled back from those lofty levels, it encouraged Bulls to rush headlong into equities. Once oil’s brief retracement ended in the high $40s, the trap was sprung. Oil resumed its trek upwards, and the trap door dropped out from under the Bulls. The Dow slumped to 10,000, Nasdaq lost 130 points, and SPX declined over 50 points. All told, the Bullish crowd had a rather miserable April.

Now, turnabout is fair play. The chessboard today looks remarkably like a mirror image of the late March setting: Oil off its recent lows is moving towards new highs in the mid-$60s; This has emboldened the Bears, who may try to press their advantage, buying crude ands shorting equities. As the long overdue pullback gets underway, its easy to see Oil to get the blame - as opposed to a conventional backing and filling consolidation.

Crude seems to be catching all the blame for Market weakness; we could see a very similar trap established - only this time, to the upside. Imagine: Crude generating headlines as it closes over $60; on the run to $63, it scares Bulls and encourages Bears. Shortly thereafter, a rapid fall below $60 again catches Bears leaning the wrong way, and Bulls underinvested. Short covering fuels the initial move in equities, before technicals and momentum take over.

This is why we believe Traders should increase exposure to equities as the market pulls back towards support levels of Dow 10,400, Nasdaq 2,000, and SPX 1,181 for a strong second half rally.

Monday, June 20, 2005 | 12:20 PM | Permalink | Comments (0) | TrackBack (0)
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