Analyzing Relative Strength of the Markets

01/07/2009 10:49 am EST

Focus: STRATEGIES

We have argued—repeatedly, actually—that the broad US stock market will recover once the oils begin to lose relative strength. While one might think that crude oil futures prices tumbling from around $147 to less than $40 would get the job done, the major oils continue to show rather impressive relative strength. We start off today with a chart-based look at this relationship.

Below is a comparative chart showing the ratio between the Amex Oil Index (XOI) and the S&P 500 Index (SPX), and the ratio between crude oil futures and the CRB Index from early 1998 into 2003.

If we had shown a longer-term comparison, a very strong case could be made that the trends for the XOI/SPX ratio and crude oil/CRB Index are virtually identical. In other words, when oil prices are stronger than general commodity prices, the oils are stronger than the broad equity market. Conversely, when crude is weak relative to commodity prices, then the oils are typically weak relative to the S&P 500 Index. We trust that this makes intuitive sense.

The relationships have diverged, however, with the most recent example occurring back during 1999 and 2000. The crude oil/CRB Index ratio pushed sharply higher through 1999 and into 2000 even while the XOI/SPX ratio held near the lows. Why? Because the techs and telecoms were attracting all the money.

The point is that the base trend for the XOI/SPX ratio is similar to that of the crude oil/CRB Index, although during periods of extreme emotion—either fear or greed—the trends can diverge. Such has likely been the case since mid-2008 as the ratio of crude oil to the CRB Index declined rather dramatically even as the XOI/SPX ratio held very close to record highs.

Our view is that the markets are behaving in a manner similar to 1999. At that time, strength in tech and telecom limited the flow of capital into the oils, while in the current time period, weakness in the financials has kept money from leaving the oils. In other words, even with sub-$50 crude oil prices, the markets are loathe to move away from the oils, and in fact, appear ready to pile back into them at every opportunity simply because they represent a sense of stability in a very unstable world. All of which brings us back to our original point: The broad US stock market will begin to recover once the oils start to lose relative strength.

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By Kevin Klombies of TraderPlanet.com

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