Article originally submitted to subscribers on 21st May 2007...

It took me by surprise!

I noticed the Amex Oil Index recently broke out to fresh highs after moving above a 1½ year congestion zone.

The first thing I wondered was - what does this meant for the price of Oil? Will it re-challenge its July '06 highs of $79? And what would that mean for the stock market?

It's worth noting the relationship between Oil and the Oil stocks is not as clean as Gold and Gold stocks.

Gold Stocks lead and the metal follows soon after in the same direction. Not so with Oil.

Oil Stocks can diverge from the price of Oil for long periods of time, as can be seen below when Oil Stocks moved higher between 1992 and 1998 whilst the price of Crude hovered around $20/barrel.The reason, Oil Stocks behave like regular stocks in that they benefit from an increase in growth expectations, quite independent from movements in the price of Oil.

Chart 1 - Oil Index looking overbought; Crude Oil (top)

Even though it recently broke to fresh highs, the Amex oil Index is currently over-extended:

• The index is nearly 40% above its 200 day moving average;
• The RSI is above 70 in over-bought territory;
• Based on my Fibonacci work, the current wave that began at 406 is very close to completion at 1400.

Compare that with Crude (top) which is only about 20% above it 200 day moving average and the internal indicators (not shown) are not overbought.

So does a fresh break to new highs in Oil Stocks mean Crude is about to bust out?

Maybe!

Due to the extreme divergences that can exist between Oil Stocks and Oil, we cannot necessarily assume Crude will move higher just because the Oil Stocks have.

But here's an indication that it might:

Chart 2 - Gasoline vs. Crude Oil (behind)

Gasoline Prices have been on a tear lately.
The main reason is bottle necks at refineries.
But take into account that we are fast approaching driving season, hurricane season, and never-ending geopolitical strife in the Middle East; one can be forgiven for thinking the price of Gasoline will be heading much higher.

A move above $2.50 would clinch it from a technical point of view. Projecting a target of $3.70. That may very well mean gas at the pump of $5 in some areas. Ouch!!

Based on the close correlation between Gasoline and Crude, a breakout in gasoline would surely be followed by a breakout in Crude!

And that brings us to the stock market. What does a breakout in Crude prices mean for the stock market?

Chart 3 - Oil Stocks : Crude Oil ratio; S&P (below)

During periods when Oil Stocks outperform Crude Oil, the stock market is usually bullish (the above chart is rising). When Oil outperforms the Oil stocks, the stock market does poorly as can be seen between 2000 and 2002. In other words, rising Oil is not necessarily bad for the stock market as long as Oil stocks are rising.

Current Interpretation: The AMEX Oil Index in Chart 1 looks very over extended technically whilst Crude Oil in Chart 2 looks like it may be setting up for a run to its previous highs. Under such conditions the Oil Stock: Crude Oil ratio would decline which as mentioned above is not good for the stock market.

$5 Gas may very well be the consumers' nemesis. The point where the consumer retrenches and reigns in spending. At least that's what the market is telling us!

Implications for Gold: A rising Oil price and a falling Stock Market would be a heady cocktail for investors. Inflation would be undeniable and the prospect of money printing to stem a falling market would be huge. Gold has a promising future indeed!

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