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Will Rallying Oil Set a Bear Trap?

Posted By Barry Ritholtz On June 20, 2005 @ 12:20 pm In Commodities,Markets,Psychology,Trading | Comments Disabled

The recent sideways consolidation has been far shallower and
more contained than many traders expected. We read this as confirming our prior
views that there remains a large contingency of underinvested hedge funds (and
others) who are now dip buyers. We also note, however, that Mutual funds are
running with bearishly low cash levels [1]  of cash on hand. The
latter could lead this consolidation lower, while the former is what could keep
this retracement well contained.

More interestingly, we have been watching Oil’s rise and
would like to bring to your attention a somewhat counter-intuitive potential
this surge has. Namely, Crude oil making new highs (see nearby chart [2]) creates a
potential for a “Bear Trap.”

You may recall our prior discussions [3] in March of this
year, where we looked at the double top in Oil at $57 as creating likely a
“Bull Trap:” As Crude temporarily pulled back from those lofty levels, it
encouraged Bulls to rush headlong into equities. Once oil’s brief retracement
ended in the high $40s, the trap was sprung. Oil resumed its trek upwards, and
the trap door dropped out from under the Bulls. The Dow slumped to 10,000,
Nasdaq lost 130 points, and SPX declined over 50 points. All told, the Bullish
crowd had a rather miserable April.

Now, turnabout is fair play. The chessboard today looks
remarkably like a mirror image of the late March setting [4]: Oil off its recent lows is moving towards new highs in the mid-$60s; This has
emboldened the Bears, who may try to press their advantage, buying crude ands
shorting equities. As the long overdue pullback gets underway, its easy to see
Oil to get the blame – as opposed to a conventional backing and filling
consolidation.

Crude seems to be catching all the blame for Market
weakness; we could see a very similar trap established – only this time, to the
upside. Imagine: Crude generating headlines as it closes over $60; on the run
to $63, it scares Bulls and encourages Bears. Shortly thereafter, a rapid fall
below $60 again catches Bears leaning the wrong way, and Bulls underinvested.
Short covering fuels the initial move in equities, before technicals and
momentum take over.

This is why we believe Traders should increase exposure to
equities as the market pulls back towards support levels of Dow 10,400, Nasdaq
2,000, and SPX 1,181 for a strong second half rally.


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2005/06/will-rallying-oil-set-a-bear-trap/

URLs in this post:

[1] low cash levels: http://www.marketwatch.com/news/story.asp?dist=&param=archive&siteid=google&guid=%7B2DF0031C%2D4EFC%2D4914%2DA7B6%2D3AABE98F650A%7D&garden=&minisite=

[2] chart: http://bigpicture.typepad.com/comments/2005/06/chart_of_the_we_2.html

[3] prior discussions: http://www.thestreet.com/_rms/comment/barryritholtz/10214526.html

[4] March setting: http://bigpicture.typepad.com/comments/2005/03/the_trap_is_set.html

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