Swift market collapse. Gloom and doom. When we will see a return to a boom? Or a bounce?

We have seen this movie before since history tends to repeat itself. That is why we can tell you when the market bounce signal will occur and all will be right in the world again. While not an exact science, history has shown that there is a correlation between sharp oil price drops and subsequent declines in stocks, and gains in oil prices to be followed by gains in stocks, due to a perceived in the economy.

One does not have to go back too far to find some of this data. In late July when we called the market top, one of the reasons for the call was the sharp 5% in the price of oil.

Crude prices have dropped by around 18% in the past 2 months  and have played a major role in the recent sharp decline in stocks as oversupply, slowing economic demand and valuations have weighed on us.  

We wrote about the oil/stock performance correlation back in an issue of the Guide in late June 2012. After oil prices collapsed and reached a low, prices swiftly rose by 22% in the next 60 days.  The S&P 500 Index and Russell 2000 indices both enjoyed a roughly 10% gain as well. Here is an excerpt: 

We are all watching the drops in oil prices and of course our wallets are thankful for this event.  After all it has dropped 25% in about 2 months.  The problem is that big drops in oil and other commodities usually portend a decline in growth.  If one looks at charts going back 30 years there is a clear correlation between a drop in oil prices and a subsequent decline in growth and stocks.  Conversely, there is a correlation between a rise in oil prices and a jump in growth and therefore the stock market.  One of the few times this did not happen was associated with very large increases in a short period that occurred during poor economic times. (See 2008-2011.)

Oil and Stock Performance Correlation

So what does this portend? We do not have a crystal ball and therefore cannot predict when the current oil price cycle will cease or begin to generate a base.  If we had to guess there is probably another 10%+ that needs to be flushed out in order to generate the base. 

In our mid-June 2012 example, oil prices dropped from about $105 per barrel to under $80 over a 14 month period before beginning its rise. I suspect that the bottom could occur in the next couple of weeks as the collapse in oil and stock prices have been swift.

Trading Thoughts

Technically, the S&P 500 Index appears to have the potential of making a double bottom to match the drop this summer. However, with the index perilously above the 200 DMA, and so many things weighing on stocks such as the dollar, Europe's declining economy, etc. it is more likely that this double bottom does not occur and we have more drops in our future.  From a valuation perspective, if the S&P 500 reaches the 1800 mark (a drop of 5% from here), its forward 12-month P/E would be 15x which could be viewed as a favorable risk/reward and catalytic entry point.

In the meantime, as we have pointed out in various publications such as the Guide in recent weeks, short term trading or sideline sitting are the best moves right now. For the daring trader, the "Ebola stocks" such as Tekmira (NASDAQ—TKMR), Lakeland (NASDAQ—LAKE) and Chimerix (NASDAQ—CMRX) will still be in play. The first and last of this group are in the biopharma arena while LAKE sells hazmat suits which are selling better than hotcakes. Separately, with volatility back in the game, our old pal TVIX remains the risky but potentially profitable day trade play. (See our summer issues of the Guide and Market Monitor for more information on this security.)

We may get a market bounce or two in the near term but until the capitulation phase hits, be wary that they are likely fleeting and false, until oil prices stabilize and we approach the end of Q3 reporting season.  

Have a great week!