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April 20, 2007

Oil and the Dollar Under the Microscope
by Clif Droke

Oil and gas stocks had a great run to the upside following the correction low in earlier March. The Amex Oil Index (XOI) rallied nearly 180 points from its March low of 1,100 to its most recent high of 1,280. The Amex Natural Gas Index (XNG) was likewise bullish from March through late April and rallied from its correction trough of 440 to its latest high of 500.

How much energy is left in the oil/gas stock sector after this extraordinary rally? To answer that question we turn to the internal momentum indicator series known as OILMO.

Earlier last month I pointed out that the dominant interim momentum indicator for the oil stocks would turn up strongly into March and April and would most likely allow for some impressive gains to be made in the leading oil stocks. This turned out to be the case as 120-day oil stock internal momentum reversed in early March and roared ahead into April, allowing the XOI to rally. This week, however, witnessed the peaking of the 120-day oil stock momentum indicator (OILMO). Based on my rate of change calculations the peak has most likely been seen for 120-day momentum for some time.

It's somewhat sad that the most vigorous part of the rally is ending (or so it appears); however, the trend is still technically bullish and there appears to be enough lingering upward bias to not only keep the sector afloat near the recent highs for a while longer but also to allow a few stocks to make higher highs, especially those that are in a relative strength position versus the XOI and XNG indices. There may even be a few turnaround attempts among the lower-priced stocks, which we'll look at in coming reports.

Meanwhile, the 5-day, 10-day and 20-day price oscillators for the XNG index have all pulled back from an "overbought" extreme to a more normal reading. This takes some of the pressure off the gas stocks in the immediate term. Based on my rate of change calculations the 20-day price oscillator for the XNG will remain neutral to slightly oversold in the coming two weeks and this should allow XNG to maintain price support above its 30-day and 60-day moving averages.

On the oil front, a recent front page headline in the Financial Times newspaper proclaimed that "Iraq could have twice as much oil as estimated." The report was based on a study from the consulting firm IHS and it estimated that Iraq's production could be increased from its current rate of less than 2m barrels a day to 4m b/d in about five years, if international investment begins to flow. This potential increase in oil reserves is only the tip of the iceberg as other "mystery" supplies of oil will be announced in the coming months. This will keep the oil price in check and will prevent the oil price-related economic crunch the bears have been expecting.

Dollar collapse?

Will the U.S. dollar experience a catastrophic collapse? Books and articles galore have been showered upon the public in which the writers purvey a coming dollar crash, a scenario which they say will destroy the U.S. economy as well as render the dollar a has-been among the major world currencies. Could such an event actually transpire in 2007?

Dollar bears point out that the dollar's weakness so far this year is due to a perceived deterioration in "U.S. economic fundamentals as well as a rise in implied inflation." (Financial Times, April 20). A chief currency strategist at Danske Bank was quoted as saying, "Historically, a stagflationary environment has been bearish for the dollar."

With monetary liquidity making a major rebound in the U.S. and the growth stock outlook looking most promising, capital inflows will end up sustaining the dollar and preventing a stagflation-type of environment that the gloom-and-doomers keep preaching. The simple fact remains that the dollar is still the world's reserve currency and as long as it maintains its top status it will be supported and kept from crashing. There will undoubtedly be periods of weakness, perhaps even extreme weakness, but such weakness won't be allowed to develop further into an outright collapse. The dollar has been likened by one observer to a cancer patient: the poor unfortunate is given chemotherapy to the point of death, then resuscitated with vitamins and allowed to restore white blood cell count for a while. Then back to the chemo and the inevitable decline in health that follows.

Same story with the dollar: strong dollar, weak dollar, strong dollar, weak dollar....it's all part of how the global financial system operates -- a fact which apparently escapes the dollar perma-bears. They don't seem to grasp that currency fluctuations are part and parcel of how the world's financial markets and economies are run; further, that periods of weakness, sometimes prolonged weakness, are inevitable.

The news media will also use the weak dollar as a proverbial "big stick" to beat the public on the head and scare them into selling stocks whenever it is needed, as was done in part during the late February/early March stock market correction. This is all part of the gamesmanship that keeps the average retail investor out of equities while the smart traders buy stocks on the cheap. Therefore it shouldn't be surprising if the recent talk surrounding the sub-prime mortgage market is soon supplanted by talk of an "imminent dollar collapse." But as weak as the dollar is now, it won't be allowed to suffer a catastrophic decline.

The latest headline in the Financial Times has once again put the spotlight on the latest dollar weakness. Now it's time to watch for the dollar bears to come out in full force, growling all the way. The U.S. dollar index has fallen to a major benchmark low at the 82 level and is threatening to test the major long-term low at 80. Support should be encountered in the dollar somewhere between the 80 and 82 levels followed by a period of base building and eventually a reversal of the weakness. Already the dollar index has made a downside "channel buster" which normally implies exhaustion of the short-term downtrend. The dollar index has made three successive channel busters below the lower boundary of the downtrend channel that has been intact since January of this year. See chart below for details. A triple channel buster usually succeeds in at least ending the short-term downtrend.

Another point well worth considering is the relationship between the dollar and interest rates. In particular, the 3-month T-Bill Discount Rate can be used as a leading indicator for the direction of the dollar. As Carl Swenlin points out in his Decision Point web site: "The direction of interest rates is an important element affecting the dollar. Rising rates give the dollar strength and falling rates bring weakness. Changes in interest rate trends tend to lead the dollar by about a year." Note the dollar vs. interest rate chart below.

As you can clearly see, the T-Bill rate has been rising steadily since 2004. It's time for the dollar to respond by establishing support above its long-term base line and reversing its current weakness, an event that should be witnessed in the coming months.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving internal momentum and moving average systems, as well as securities lending trends. He is also the author of numerous books, including "How to Read Chart Patterns for Greater Profits." For more information visit www.clifdroke.com.

Copyright © 2003-2008 Clif Droke

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