Averages Hit Oil Slick

3/7/2011


With widening turmoil in the Middle East lifting oil prices, the Dow Industrials have hit the first sustained selling pressure since November. The Dow Transports, highly sensitive to energy prices and economic-growth rates, have slumped roughly 6% from the Feb. 17 closing high of 5,298.10.

While we would not be surprised by further weakness in the near term, we are inclined to view a decline as a secondary correction in an ongoing bull market. For now, as a partial hedge, our buy lists are maintaining a 10% to 15% bond-fund position as we look for buying and selling opportunities on a stock-by-stock basis.

Oil worries

A jump in oil prices acts as a tax on consumers, siphoning money that otherwise could be spent on other items. By some recent estimates, a 10% increase in the price of crude oil cuts growth in global gross domestic product by about 0.25%. With consensus forecasts projecting 2011 economic growth above 4% for the world and 3% for the U.S., the jump in oil prices seen thus far seems unlikely to tip the world or the U.S. into recession.

Spot prices for Brent crude oil, the benchmark for about two-thirds of the world's oil, have jumped 18% in 2011 and 11% since Feb. 15, when the strife in Libya erupted. Yet Libya accounts for less than 2% of the world's oil supply, and Saudi Arabia has pledged to make up any shortfall in Libyan production. Clearly, investors are worried about the potential for unrest to spread.

If disturbances somehow interfere with oil production in Saudi Arabia or Iran, many analysts expect the record prices reached in 2008 to be tested. The Saudi Arabia stock market has slumped about 20% over the past three weeks, and the cost of insuring the kingdom's debt has jumped to the highest level since July 2009.

If investors gain confidence that the unrest is unlikely to spread to Saudi Arabia or Iran, oil prices should stabilize or recede. At that point, action in the major U.S. averages could prove telling. A rebound above the mid-February closing highs of 12,391.25 in the Industrials and 5,298.10 in the Transports would signal that investors do not expect higher energy prices to derail the global recovery.

Conclusion

Oil prices represent a potentially huge near-term wild card for the stock market. While holding a 10% to 15% position in short-term bonds seems prudent for now, we are looking for opportunities to put money to work in stocks. For new buying, especially attractive technology names include Focus List selections Altera ($41; ALTR) and Lam Research ($55; LRCX).


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