Could Oil Prices Intensify a S&P 500 Selloff?

Last week we received reports that the unemployment rate in the United States was improving markedly. In addition, sentiment numbers were released that confirmed my previous speculation that market participants were becoming more and more bullish as prices in the S&P 500 edged higher. The exact numbers that came in demonstrated that bullish sentiment had not reached current lofty levels since February 11, 2011. The table below illustrates the most recent sentiment survey:

Clearly investors are growing considerably more bullish at the present time. The bullishness being exhibited by market participants is rather interesting considering the notable headwinds that exist in the European sovereign debt markets, the geopolitical risk seen in light sweet crude oil futures, and the potential for a recession to play out in Europe.

Chart Courtesy of the American Association of Individual Investors

To further illustrate the complacency in the S&P 500, the daily chart of the Volatility Index is shown below:

The VIX has been falling for several weeks and is on the verge of making new lows this week. If prices work down into the 16-18 price range a low risk entry to get long volatility may present itself. For option traders, when the VIX is at present levels or lower there are potentially significant risks associated with increases in volatility.

My expectations have not changed considerably since my article was posted last week. However, I continue to believe that the bulls will push prices higher yet in what I believe could be the mother of all bull traps. Let me explain. As shown above, we have strong bullish sentiment among market participants paired with general complacency regarding risk assets.

As I pointed out last week, my expectation if for the S&P 500 to top somewhere between 1,292 and 1,325. A lot of capital is sitting on the sidelines presently and if prices continue to work higher I suspect that a move above the 1,292 price level will trigger a lot of long entries back into stocks or other risk assets.

We could see prices extend higher while the "smart" money sells into the rally. Retail investors and traders will point to the inverse head and shoulders pattern on the daily chart of the S&P 500 and the breakout above the key 1,292 price level. The pervasive fear of missing a strong move higher will help fuel long entries from retail investors.

At the same time retail investors begin buying, a lot of committed shorts will be stopped out if prices push significantly above the 1,292 area or higher toward the more the obvious 1,300 price level. Thus, there will be few shorts to help support prices should a failed breakout transpire. A perfect storm could essentially be born from the lack of shorts to hold prices higher paired with the trapping of late coming bulls.

The daily chart of the S&P 500 Index below illustrates what I expect to take place in the next few weeks:

I want to reiterate to readers that it is not totally out of the question that the 1,292 price level could hold as resistance or that we could roll over early this coming week. Additionally a breakout over 1,330 will certainly lead to a test of the 2011 highs around the 1,370 area.

If the S&P 500 pushes above the 1,370 area we could witness a strong bull market play out. Ask yourself this question, what reasons could produce such a rally and what are the probabilities of that outcome transpiring in the next few weeks?

Obviously earnings season is going to be upon us shortly and if earnings come in below expectations a potential sell off could intensify. Furthermore, economic data in Europe continues to weaken and slower growth appears to be manifesting within the core Eurozone countries like Germany and France. If most of Europe plunges into a recession, deficits will widen beyond economic forecasts and the strain in the sovereign debt market of the Eurozone will increase dramatically.

One key element that many analysts are not even discussing is the potential for higher oil prices to present additional economic headwinds for developed western economies.

Clearly the situation in the Middle East is unstable, specifically what we are seeing taking place in the Strait of Hormuz involving Iran. If a "black swan" event occurs such as a military conflict between the United States and Iran or Israel and Iran the prices of oil will surge.

In a recent research piece put out by Soci'et'e G'en'erale, nearly every scenario that is referenced involves significantly higher oil prices. According to the report, the euro-zone is considering the banning of imported Iranian oil which could cause Brent crude oil prices to surge to a range of $120-$150 / barrel according to SocGen.

The other scenario involves the complete shut down of the Strait of Hormuz by Iran. If this shutdown were to persist for several days the expectation at SocGen for Brent crude oil prices is in the $150-$200/barrel price range.

Clearly if either of these two scenarios play out in real time, the impact that higher oil prices will have on European and U.S. economies could be catastrophic.

The daily chart of light sweet crude oil futures is shown below:

I want readers to note that I am not suggesting that oil prices are going to rise or fall, just outlining the report from SocGen about where they expect oil prices to go should either of the two scenarios presented above play out. If oil prices were to work to the $125/barrel level and remain there for a period of time, I would anticipate a very sharp decline in the S&P 500.

Currently there are a lot of headwinds for bulls, some of which could persist for quite some time. I intend to remain objective and focus on collecting time premium as a primary profit engine for my service at OptionsTradingSignals.com.

Once I see a confirmed move in either direction I will get involved. For now, I intend to let others do the heavy lifting until a low risk, high probability trade setup presents itself. Risk is increasingly high.

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J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis.