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Typical August trading patterns are here. Microcaps tend to grind down on very light volume as most individual investors are off enjoying the summer months and not too focused on their stock market investments. On the plus side, a little buy side volume usually restores these stocks back to reasonable levels.  Current BLOG entries include thoughts on AGSI, NWWV, and GEPT. 

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Market Defies Gravity in the Face Of Higher Oil

In the mid and large cap arena we've enjoyed an outstanding summer rally square in the face of rising oil prices and higher interest rates. How can this be? Aren't higher oil and interest the enemy's of prosperity? Doesn't this environment signal a death knell for stocks?

The S&P 500 traded to it highest level since June of '01 on August 3rd. The S&P is up 9.4% since the April low. The good news- large caps are coming back. The bad news- if you have been in an S&P 500 index fund for the past four years, you just broke even. Pathetic.

In Q1 of '05 the market sold off everyday as oil prices rose. We're now pushing $70 per barrel- and the market is behaving as if it wants to put in a strong year end rally. What gives?

Here's what I believe is happening. I believe the market has grudgingly decided to admit that higher oil prices and higher interest rates are not killing the economy. With corporate earnings at record highs and corporate balance sheets in great shape, market participants are starting to bid up stocks.

Let's look at some factors. If you tune in the talking heads on CNBC, you here are parade of negative commentary on the economy. Yet, here are the facts:

• Real GDP is at record levels- we are now an $11 trillion economy headed to $15 trillion.
• June unemployment rate is 5%- below the 30 year average of 6.6%
• Industrial production is at record levels- up .9% in June.
• Housing starts and home ownership are at record levels.
• Monthly mortgage payments are running 15% of average income vs 18% to 22% in the 90's.
• Despite higher gas prices, CPI is a very modest 2.5%
• The 10 year treasury, the key driver of consumer interest rates, remains in the 4.25% and lower range. Higher than recent lows, but still historically very low. The 10 year treasury averaged 5.5% during the decade of the 90's when we had a raging bull market.
• Corporate profits are at record levels and growing 10% per annum.
• The dollar has rallied sharply from the lows.
• The budget deficit has improved in the past six months as a result of higher tax revenues.

Let's look at oil prices.

Here's a six year weekly chart of the price of oil. It shows what we call a "Parabolic Rise" over the past four years. The price of oil has tripled in that time frame.

Certainly, the demand/supply dynamic in oil worldwide has driven prices higher. But- really - has supply been cut to 1/3 of 2002 levels? Has demand tripled in the past four years?

Here's a fact from the Paris based International Energy Agency. While demand for oil increased 3.4% in '04, it is only forecast to grow 2.2% in '05 to 84.3 million barrels per day. So where's all this huge demand the market is forecasting?

On the supply side - supply interruptions are expected from a heavy hurricane season forecast from the Gulf of Mexico and problems in the North Sea. Those supply interruptions are already priced into the market. 

In short, although it's not a popular point of view, I believe oil prices are due to take a breather in the near future. They will either trade sideways for an extended period of time, or sell off once we get a little further into hurricane season.

Is oil going to $105 (T. Boone Pickens) or $110 (Goldman Sachs) in five years? Probably. Is oil going to $90 this year? Probably not. In fact, the extended LPO (logic profit objective) for the price of oil is about $70. This level should represent a mid term top. 

Don't be fooled by the continuous rhetoric you hear in the media. Use your common sense. Oil prices have risen virtually unabated for four straight years. Sometimes, prices go up because they are going up. Traders figure out why after the fact.  At this point, we are far ahead of the supply/demand equation. A correction is in the works. 

Between now and the end of '05, I believe oil prices will correct, we'll be near the end of the FED's tightening cycle, and corporate profits will continue to improve.

In the long term, oil prices are probably going higher. OPEC can no longer flood the market with low priced crude. They just are not the force they used to be. The low hanging fruit has been picked, and new sources will take time to develop and are often found in very hostile environments.

Seasonality will be more exacerbated than ever in the latter part of '05. September is generally the worst month of the year, followed by a roar to the finish line. This year looks like it could be setting up for a record finish as the momentum hedgies crawl all over themselves to get on board an already streaking train.

6,000 hedge fund managers have to participate in the year end rally to cover the costs of homes in the Hamptons and private schools. They can't afford to miss the second half surge and stay competitive. 

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