Monday, July 28, 2008
by Jim Stanton, Technical & Quantitative Analyst, Smart Profits Report The last time we checked in, I had written about a potential Dow Theory buy signal. Lo and behold, the very next day the indexes reversed and started moving higher. Primarily due to frantic short covering in the financial sector, it was still helped along by declining oil prices and a little government intervention in the short sale department. The Dow Industrials came very close to triggering a daily buy signal, which would give us a Dow Theory buy signal. But in order to accomplish that, the Dow Industrials need to trade above last week’s high. Many of the financial stocks, which were deeply oversold, rallied 50% or more off their lows before pulling back late last week. And that means that much of the short covering is over; financial stocks will now have to perform on their own merits without the help of a large, overhanging short position. Mixed Results For Nasdaq The Nasdaq indexes have been the laggards over the past two weeks due to negative reactions from earnings reports in stocks such as Google, Microsoft, and Apple. And yet, the Nasdaq 100 has performed relatively better than the Dow and S&P 500 over the last few sessions. Below is a Daily spread chart of the Nasdaq 100 over the S&P 500. This chart plots the differential between the two indexes, and is something I keep a close eye on. When the Nasdaq 100 outperforms the S&P 500, the spread price moves higher and vise versa. 
Generally speaking, all of the stock indexes usually do well when the spread is moving higher and as you can see, the spread bottomed out last Tuesday and is now close to breaking above the downtrend line. The spread differential closed last Friday at 588.79 and the downtrend line is currently around 592. Two closes above the 592 level should be a plus for all of the indexes. Oil Industry Is Still Driving Markets Crazy As I mentioned before, the financial sector and oil prices have been driving the markets lately. A although the government may have a few more tricks up their sleeve, since much of the short covering is probably over in the financial sector, I thought we’d take a look at the oil sector this week to see where it’s headed. The only stock I follow that is a mirror image of the crude oil contract is the United States Oil Fund (AMEX: USO). It trades at about a 20% to 25% discount to the price of crude oil, due to the fund’s structure, but has about a 99% correlation to crude prices. Below is a daily chart of USO, dating back to a low point in early February. 
The stock made a new high above $119 on July 11, and held its gains for a day before falling over $5 on July 15, which was the same day that the Dow and S&P made its lows for the year. USO has continued to fall since then and in the process, has closed below its 50 day moving average and the uptrend line drawn from the February lows. The stock triggered a daily sell signal and - barring a new buy signal (and there’s only a 20% chance of that) - should undergo at least an A-B-C correction to the downside. That means that when this first “A” wave of selling is complete, we should see a “B” wave rally followed by a “C” wave decline to new lows. On a short-term basis, USO is getting oversold and last Friday it tested the previous low point, which was made in early June at $98.62. If it can hold in this area, the “B” wave rally should begin shortly. When it does begin, the question is: How high will the rally go? Predicting The Oil Market Of course that’s a good question, and here’s the answer…or at least a range of possibilities. If USO rallies from this area, a number of outcomes could play out. Considering Fibonacci’s Theory, note that the 38% Fibonacci retracement is around $106.50 which means that the 50% retracement would take it up to around $108.95. It could also rally back up to the bottom of the uptrend line, which moves higher every day or, it could test the 50-day moving average, which is currently around $108. If the stock moves lower from here, these numbers will change a bit when the “B” wave rally begins but assuming that we’ll see higher prices sometime this week, I would be looking to buy some put options somewhere between the 38% and 50% Fibonacci retracement levels. If it only trades up to the $106.50 level when the “C” decline begins, the stock should drop down to at least the $96 area. Act Now On The Oil Industry But Stay Tuned To Sector Watch But just remember what time of the year we’re in the middle of. You’ll notice I said I would be looking to buy puts, not shorting the stock, or selling naked calls, and there’s a good reason for that. Folks, we’re in hurricane season and if one gets into the Gulf of Mexico, all bets are off. While technical analysis is very reliable, it works off of averages, past records and trends. It quite simply can’t take into account any true surprises, which the weather is all about. Playing the short side of oil during hurricane season can be very high risk so I would take a smaller-than-average position, with limited risk. Cheap puts are the best way to go right now. That’s all for this time. Jim Stanton
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