We have to take a time out and ask ourselves some sharp questions at this point, because the action in the crude pits is beginning to resemble what we saw at mid-year, 2008, when oil slid like a bursting, jam-filled donut down Chris Christie’s gullet at the 4th annual New Jersey Obesity Awareness gala.
In fact, it was just two weeks ago that fellow Normandy scribbler Matt McAbby discussed the importance of the precipitous decline in crude in his letter called A Crude (But not Vulgar) Pairs Trade, wherein he also put together the following chart that matched the action on the equity market with that for oil during the 2008/2009 market meltdown.
We borrow it now with his blessing for your perusal –
As Matt made clear, the steep slide in oil (in blue, at top), represented by the U.S. Oil Fund ETF (NYSE:USO), was a clear harbinger of the death spiral in the S&P 500 that followed later in the year.
Moreover, oil’s bottom in February of 2009 also came a month before stocks hit their lows and began to turn up (above volume peak, in black).
And our question today is, whether recent technical weakness in crude oil is again signaling a sharp sell-off to come for the S&P 500.
Let’s have a look at the chart for some clues.
Here’s the way crude sets up for the last six months –
The last major low for crude was logged in the summer of 2012 when she bottomed at $77.28. Since then, she’s climbed steadily to a peak of $112.24 last summer, dropped to her February, 2014 lows (seen at far left), then climbed again to her latest retracement high (marked: HEAD) of just one month ago.
And that’s where we sit today.
Because as we’ve noted on the chart (in blue), crude has also traced out an apparent 11-week head and shoulders top formation whose neckline (in red) was just broken last Friday and whose downside count could bring her as low as 91 before traders begin looking for a re-entry point.
Finger Lickin’ Messy!
In short, things could get very sticky for oil investors over the near term if volume picks up on the downside for crude. The key to what happens next will be found in today’s trade. If volume picks up on the downside, we’ll likely see continued selling until our near-term target is reached.
As for equity investors, as we mentioned above, the downturn in oil could also signal the long anticipated stock correction that’s been worrying investors for nearly 30-months now.
Quantifying the Worry
The weekly survey of the American Association of Individual Investors (AAII) shows that bullish sentiment is anything but overblown. Rather, the number of optimists among those surveyed is at the bottom end of average for the last five and a half years since the bull market began.
Have a look here –
At 31.2%, bullish sentiment is telling us that the likelihood we’ve hit a major market top is remote. Rather, it’s more likely that the current bout of selling will be limited in both scope and duration, though it may induce some nausea among an investment crowd that hasn’t seen a sizeable pullback for three years.
We note, too, that bearish sentiment among those polled by AAII has now climbed to meet the number of bulls for the first time since May of 2010, the month that coincided with the first significant selloff in the market after the bull took hold in March 2009. All of which points to the potential for a little more selling and a likely turn higher before long.
All the same we’ll be watching the developments in the crude pits and will keep you posted if our thinking changes.
Closing Out Some Open Trades
First, the bad news.
For lack of space, we neglected reporting on the following dud of a trade that cost us $0.60 when it expired last month. Today, in the interest of full disclosure, we bring it to your attention.
It was a pairs trade launched on January 6th using two Toronto listed stocks that we simply didn’t give enough time. Today, the trade would have made us money. But as we played it, we lost. Fair and square. No excuses. The letter was called Great West Canadian Power Play, and we refer you to the original article for all the details and rationale for the trade.
Bottom line – $0.60 (CAD) was lost. 100% of your initial premium.
Hugh – you’re an arse!
Now, on to a couple of winners that we’re very pleased with.
On May 26th we opened a pairs trade that matched the beaten-up Global X Funds Social Networking ETF (NASDAQ:SOCL) against the broad market, as represented by the SPDR S&P 500 ETF (NYSE:SPY).
The letter was called Facebook’s Friends Offer Filthy Lucre!, and there we suggested the Facebooks and Linkedins of the world would do better than the indexes over the short term.
And lucrative it was.
Take a look –
We bought the SOCL September 18 CALLs for $1.25 and sold the SPY September 199 CALLs for $1.28, for a total credit of $0.03.
As of Friday’s close, the SOCL CALLSs were going for $1.90 and the SPYs were trading for $1.17. That’s a profit of $0.73 plus your original $0.03, or $0.76 on nothing expended.
We say take it. Buy back the SPYs and sell the SOCLs immediately.
Finally, we launched a similar trade on the 9th of June using the Select Sector SPDR Financial ETF (NYSE:XLF) against the S&P 500 with the same expiry but with slightly less ecstatic results.
The letter was called The Next Wave Higher, and there we recommended as follows –
Buy the XLF September 21 CALLs for $1.99 and sell the SPY September 200 CALLs for $2.08, for a credit of $0.09 per pair traded.
And where does she sit today?
The XLF CALLs last went for $1.40 and the SPYs for $0.90. That’s a profit of $0.50 plus your original $0.09 for a grand total of $0.59 per pair traded – again, on no money down.
Close her down.
Sell the long CALLs and buy back the shorts.
Wall Street Elite recommends you consider closing your SOCL/SPY and XLF/SPY pairs trades as detailed above.
With kind regards,
Hugh L. O’Haynew, Senior Analyst, Normandy Research