Rising Oil Prices Crimp Stocks

3/7/2011


The stock market has pulled back in recent trading, dragged lower by a sharp increase in oil prices. While the primary trend is bullish according to the Dow Theory, a full-fledged secondary correction would not be surprising, given the market's surge in the last three months. As a partial hedge, our buy lists hold 10% to 15% positions in Vanguard Short-Term Investment-Grade ($10.78; VFSTX), a relatively low-risk bond fund.

Secondary corrections

The market's strong rally from November lows has shortened investors' memories about corrections. Secondary corrections are usually violent and abrupt, though often short-lived. The typical correction lasts three weeks to three months and retraces one-third to two-thirds of the market's previous advance. Secondary corrections are often triggered by an event, such as a bad economic report, the collapse of a prominent merger deal, or, perhaps in this case, a sharp jump in oil prices.

Oil prices have risen 13% over the last week.  Higher oil prices can hurt the economy on at least two fronts. Petroleum is an important raw material for industries from chemicals to consumer products, so higher costs could impinge on the profits of many businesses. And higher oil prices translate to higher prices at the gasoline pump for consumers.

To be sure, history teaches oil prices can fall as quickly as they rise, so it is premature to suggest that rising oil prices will short-circuit the bullish primary trend. But higher oil prices could spark a meaningful secondary correction, particularly if those higher prices occur during a period void of news that would otherwise fight for investors' attention.

Conclusion

Based on the market's advance, a correction of 900 points in the Dow Industrials would be well within the parameters of a traditional secondary pullback. However, investors should view such a pullback as a correction within a bull market. If such a correction unfolds, investors should use the pullback to acquire such technology favorites as Apple ($339; AAPL), Altera ($40; ALTR), and Texas Instruments ($36; TXN).


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