Oil rally points the way higher for stocks

West Texas Intermediate (WTI) crude oil soared to its highest level ($108.12/barrel) in mid-July since March 2012. Escalating tensions in Egypt have been widely acknowledged as a driving force behind this latest price surge. While currency fluctuations and geopolitical events can have a near-term bearing on oil prices, it is my contention that the longer-term uptrend in oil is more directly attributable to investors’ more constructive expectations for economic recovery. July’s rally in WTI may have been spurred by technical buying as its price rose above a multi-month consolidation channel. Considered in a longer-term context, however, oil at this price level represents a gradual and orderly recovery from the extreme lows set in late 2008 (~$34/barrel) amid the financial-led selling rout. There has been a consistent correlation between the price of oil and the direction of the stock market since the start of this cycle in 2002. The bottoming in oil in late 2008 portended a braking of downward momentum for stocks soon after and a decisive bottom among the major indices by March 2009. This month’s rally in oil may provide confirmation that the lion’s share of the stock market’s gains year to date are sustainable.
As oil gained ground this year, gold and industrial metals faltered. Copper, steel and coal-related stocks have begun to establish base formations that could be signaling an important bottom for commodities. I am not expecting dramatic short-term reversals for commodities, but recently improving relative strength trends in the commodity-related categories could be constructive for the general market as the potential for increased demand bodes well for the economic outlook. A gradual recovery among depressed commodities could pave the way for higher stock market levels with corrections held to relatively modest 3%-5% retreats before reaching DJIA 16,000, or higher. If commodities prove capable of rejoining the leadership fold, general market momentum could accelerate further while support is reinforced at incrementally higher levels near DJIA 15,000.
Another bullish development for equities was the precipitous drop in the CBOE Volatility Index (VIX) this month. In June, the VIX spiked to levels just a technical whisker shy of its December peaks (22.72) thereby preserving a long-term downtrend in the ‘fear index.’ In the past four weeks, the VIX has plunged from a high of 21.91 to lows approaching 12 as worries about the implications of Quantitative Easing unwinding by the Fed subside. The expansive swings in the VIX established a classical head-and-shoulders formation which augers well for the index remaining at lower levels for an extended period. In practical terms, the drop in the VIX suggests that headline risk may be abating considerably, thus providing a healthier investment climate for stocks wherein investors regard interest rate and earnings as primary factors in their decision making. This could usher in a stage in which earnings growth prospects play a more traditional and reliable role in price behavior.
The improving relative performance of small and medium capitalization (SMID) stocks may indicate a heightened focus on earnings growth prospects. Year-to-date the Russell 2000 Index has outpaced the S&P500 by 4.73%. This is an encouraging development inasmuch as it implies a greater willingness on the part of investors to accept more risk in return for the reward potentials offered by earnings-leveraged opportunities among stocks in the SMID universe. This action is not atypical of the characteristics of an advanced-cycle market setting and could place greater emphasis on stock-picking strategies. In fact, it is my expectation that second quarter earnings could move this process along as earnings results and outlooks delineate individual winners from also-rans among the leading industry categories. Such a possibility would argue against seeking underperforming stocks at this juncture on the presumption that they are ‘cheap’ and offer more attractive risk-to-reward opportunities.
Although I anticipate gradual narrowing of individual stock standouts, this is not likely to impinge on the broad and diverse industry leadership that has been the hallmark of this cycle. While the technology, health care, energy and manufacturing categories (T.H.E.M) remain among the core of the market’s leadership, other sectors continue to exhibit strong long-term relative strength as well. These include consumer discretionary and financials. Surely there have been regular rotational movements among these and other groups, but it is these areas specifically that seem to have the most resilient price characteristics. In my view, the die is cast and it is unlikely these sectors will be unseated as leaders through the remaining time of this cycle.

Eugene E. Peroni Jr. is senior vice president of equity research at Advisors Asset Management. This commentary originally appeared on the firm’s website.