U.S. Markets Could Rally on Oil Price Decline

Oil and the credit market-the same one two combination that have pummelled stocks all year-took a few wacks on Friday. Crude oil crossed US$126 in New York. While oil futures move up 8.3% for the week, the Dow moved 120 points down on Friday. Yet you still get the feeling there's a lack of conviction in the stock market about the effect of high oil prices in the real economy.

What are the two sectors that would be hit most by higher oil and petrol prices? Transport stocks and retail would seem like the safe bets. Businesses that have oil as a cost and consumers that have petrol as an expense would be on the front lines, feeling the effects of oil's steady rise. But take a look at the chart below and then rejoin us for a comment.

The chart shows the U.S crude oil exchange traded fund (AMEX:USO) against the Dow Jones Transportation Index, the retail ETF (AMEX:RTH), and the oil and gas sector (NYSE:XOI). What does it show?

Oil has been the standout for the last 52 weeks. By comparison, retail stocks are down almost 15%, the Dow Transports are flat, and the oil and gas stocks have failed to follow crude higher. If the oil price is an accomplished fact at US$126, what is the stock market waiting for? Shouldn't it be pricing in the effects of higher energy prices?

Earnings. You can see that oil's really strong run has come since February. Remember, in January of last year crude futures had actually declined below US$50. Earnings for U.S. retail stocks have already taken a hit from the reeling housing market. But we reckon this chart shows you that the market believes the higher oil price is cyclical and not structural.

If it's right, that sets up the U.S. market for a huge rally should the oil price decline. So, if you think the oil price is looking frothy, and you want a punt, what about S&P 500 calls? We have put up a chart of our own, just to see if it confirms our theory that the S&P could make a breakout on lower oil prices. Take a look.

What you can just barely see is that the upper end of the S&P's current channel is also where the 200-day moving average currently sits. This chart shows some interesting things. The S&P rallied after last August's credit market woes surfaced.

This rally proved to be premature. But it did have conviction, with the S&P making what you might call a double top above 5,550 on the bogus rally, and has been in a downward channel since. A big correction in the oil price might allow the index to break that channel. And then…well then we'd go from there.

Of course none of this may matter much in Australia. The market here is taking its cues from rising resources prices. And even Aussie financial stocks are bucking the bearish U.S. trend. The National Australia Bank reported $2.24 billion in six-month earnings. NAB was up 4%. Compare that with American insurer AIG. The firm lost US$7.8 billion in the first quarter and the stock was down 8.8%.

AIG took big write-downs on credit derivatives. By "big" we mean around US$9 billion, as the company was forced to mark some assets to market value. Those assets-credit default swaps-are not exactly cash or near cash. AIG says it will seek to raise US$12.5 billion in new capital.

But hey, it's not alone. Citigroup wants to sell US$400 billion in assets to raise capital and revenue this year. You read that right, US$400 billion. Citi has US$2.1 trillion in assets. That's why it's the largest U.S. consumer bank. But the garage sale is one now.

This shows you how inflated asset values are in U.S. financial stocks. The combined market caps of Australia's two largest miners (BHP and Rio) is $338 billion.

Speaking of the miners, it looks like China Inc. has largely conceded it that pricing power in the resource market has swung towards the producers. So Plan B, as we mentioned last week, is to get some equity in the producers. And if BHP is off limits for a takeover, then the Pilbara's third-largest iron-ore producer will do just fine.

"Chinese circling Fortescue," reports today's Australian. While that story plays out in the press, there is real activity on the ground. We'll have a report from Diggers and Drillers editor Al Robinson later this week.

The Federal Budget comes out this week. But the bigger data release is probably the wage price index. The RBA confessed on Friday that inflation looked like staying outside its 2-3% comfort zone. If wages start moving up to match rising petrol and food prices, look for a re-think on rates. That is, higher wages make it likely the bank will raise rates again instead of standing pat.

Goldman Sachs says US$500 billion. That's the total credit market losses from the U.S. housing bust. A research note last week concluded, "We think that overall mortgage credit losses will end up being larger than generally believed." Believe it.

Dan Denning
The Daily Reckoning Australia

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