Oil is a compelling reason the sell-off in stocks isn’t over

If you are wondering if this rebound in the S&P 500 (NYSEARCA: SPY) will hold, if the selloff and bear market is over, they’re not. The CPI for October was better than expected and the market cheered, delivering a solid 5%+ move, but there is a single reason to fear another surge in inflation, another spike in FOMC activity and a sell-off in stocks is on the way.

That reason is oil (NYSEARCA: USO). The reasoning is this: oil underpins the cost of everything and it is going to get more expensive over the next 3 to 6 months at least. Just look at the post-CPI action alone. The price of WTI spiked more than 3.5%, sustained the gain, and confirmed support at a key trend line, the chart will follow. 

The oil connection

Oil is a leading input cost at all levels of the economy from the basic material producers to the discretionary retailers and the consumer itself. The CPI was better than expected and caused the dollar to fall and, because oil is priced in dollars worldwide (a situation dating back to the collapse of the gold standard), oil gets more expensive.

This is a classic example of good news being bad news (except for the big oil companies). If the FOMC is actually able to back off of its rate-hiking trajectory the price of oil will go up and cause another series of negative feedback loops within the economy as those price increases filter through.

Looking at the chart of WTI, the price of oil has corrected over the past few months and quarters but it’s still trading at an 8-year high and showing signs of clear support. This is because the fundamentals in the oil market are tilted in favor of higher prices even without the aid of a weaker dollar.

According to the latest IEA Oil Market Report, production is peaking out at around 101.2 million barrels per day with OPEC+ on track to tighten production. This is slightly less than the 101.3 MBPD in expected demand and enough of a tilt to keep oil prices supported if not moving higher. 

Inflation, it peaked? Yeah right

So, the CPI data shows the pace of inflation cooled from the previous month but it is still hot and we’ve seen this before. The pace of inflation peaked in March this year and slowed but only to 4.7% core PCE which is still quite hot, and then it accelerated.

Inflation is coming down in some areas but is underpinned by housing costs which are only going up with interest rates on the rise and new homeownership slowing. The pace of home price increases is slowing, yes, but not expected to contract substantially and, if it did, that would be another major blow to the home-building industry and the economy at large. 

So, the CPI was better than expected and it has peaked, again, but inflation is still high and leading the FOMC to increase interest rates, if slower than at the previous pace. The December meeting should bring a 50 basis point hike at least which is helping brighten the outlook but only relatively speaking. Like when the sun tries to shine through the fog only there is a monster lurking in the mist and its name is Higher Oil Prices. 

The technical outlook: WTI is set up to move higher 

The price of WTI has corrected but it is also showing clear signs of support at a key level. This support is manifesting itself in the form of a Head & Shoulders Reversal Pattern (on the weekly chart) that is so tight that it is almost a Vee-Bottom.

The reversal is not technically completed, it still needs to break above the 150-day EMA which is consistent with the Neckline of the pattern, but the conditions are highly favorable that it will. In this scenario, the stochastic and MACD will fire a strong, trend-following signal in tandem with each other and, if you look closely, you will see that MACD already is. So, is oil going higher? There is no way to guarantee it will but there is almost no reason to think that it won’t.