Crude rally gathers pace but stocks fail to respond

Crude’s rally gathered pace on Thursday, with Brent oil surging through the $50 hurdle and WTI climbing above $48 a barrel, as we highlighted the possibility in our oil report yesterday. So far however, US equity indices have not followed oil higher, which serves as a reminder that correlations can and do break down or become weak from time to time. But if crude oil is able to sustain its gains in the coming days then this should obviously be good news for the energy sector, which may be enough to lift the Dow Jones Industrial Average to new unchartered territories soon. Indeed, with the likes of Chevron and Exxon being well off their mid-July highs, one could argue that they have some catching up to do with both oil prices and the wider stock markets in general. Either that, or the stock market participants do not believe that this crude oil rally will be sustained.

Crude surges higher

Crude oil has been rising sharply in recent days mainly on short-covering with hedge funds and other large speculators raising their net long positions once again. To some degree, this is because some believe – or more appropriately, hope – that the OPEC may come up with a plan to support prices at its informal meeting next month, something which we doubt will happen. The gains can also be attributable to the weekly US oil report which was published by the EIA yesterday. As a reminder, the report showed a surprise fall in US crude stockpiles with inventories of gasoline also falling more sharply than expected due to a higher rate of crude processing by refineries and as imports declined slightly. But there was a marked increase in total US oil production which the market has chosen to ignore for now. Evidently, it is expectations of stronger demand rather than just an expected reduction in the oil glut that has helped to support prices. Still, with US driving season being at its twilight, demand from refineries should begin to ease in the coming weeks, causing oil inventories to rise again. This should put a temporary ceiling on prices, although for now momentum seems to be behind oil prices and the rally could easily extend another $5 or so bucks, if not more. As I have repeatedly mentioned in the past, I expect oil prices to hover in the range between $45 and $65 a barrel in this second half of 2016.

Stock market hesitation can be short-lived

But going back to the equity markets, oil is obviously just one factor that affect stock prices. It could be that the stock market participants are not buying this oil rally this time. But just because the markets are not rising strongly today, it doesn’t mean they won’t do so tomorrow, or next week. It is just that apart from oil, there is no fresh catalyst to drive stocks further higher. Equally, there is no compelling reason for speculators to all of a sudden sell equities, not when the major indices have just broken out of their 1.5-year consolidative ranges. Thus, the hesitation here can be short-lived. We remain bullish on stocks because of the ongoing central bank support in the form of QE and low and negative interest rates across the globe. Though admittedly valuations do look a little stretched, it is the lack of alternatives which provide decent yields at acceptable levels of risk that makes me maintain my bullish stance on stocks.

Technical outlook: DJIA

From a technical perspective, the recent break of the Dow to fresh all-time highs is far from being a bearish scenario. However, in the short-term, it appears as though the bullish momentum has ran out of gas, for the index has broken back below its prior high of 18620 and the RSI has formed a negative divergence (lower high) near the “overbought” level of 70. So we may see some choppy price action here for a while, which is a characteristic of the markets at this time of the year anyway. But as long as the old all-time high at 18350 is defended, bullish traders will not be too concerned. There are lots of levels that could potentially provide support, including those shown on my chart in blue. The most important one for short-term traders is at 18470, where the Dow bounced from yesterday to create a hammer-like candlestick pattern on its daily chart. This is obviously a bullish pattern, but there has been little or no follow-through in the buying momentum thus far today, which must be frustrating for the bulls. Meanwhile in terms of resistance, the pivotal level to watch is 18620. Beyond that, there are a couple of Fibonacci extension levels where we may see some profit-taking around, at 18850 and then 19160 – see the chart for details.