Will SP500, Silver, Gold & Oil Break Out?

Source: J.W. Jones, Options Trading Signals  (4/22/11)

"Just how high will silver, gold and oil go before they top?"

The price action in the financial markets this week has added to the continued confusion about where equity prices are headed. Precious metals and oil prices have been working higher for quite some time, but equity prices have been rather range bound now for over a month. Currently, the SPX looks poised to test the recent highs after selling off harshly this past Monday.

Monday's price action in the SPX is a perfect example of panic level selling washing out weak investors and running stops right before an intermediate term bottom is formed. It happens quite often and for many the frustration is overwhelming. On Monday, multiple market pundits were saying there was a double top on the SPX daily chart and prices were going to cascade lower. At the same time, these so-called market experts were declaring a double top on CNBC, the market internals were declaring the potential for a bottom to form.

Since Monday, the SPX has rallied and is running into resistance early Thursday morning. I would not be shocked to see some consolidation at these levels the rest of the day and possibly early next week because the SPX has made a significant move higher in a short period of time. Some of the move has been inspired by stronger earnings forecasts, which I alluded to in my previous article. The hourly chart of SPX shows the strong upward move that we have witnessed this week after Monday's selloff.

$SPX

The other catalyst pushing the S&P 500 higher was the weakening U.S. dollar. The following quote came from my previous article, "If the dollar breaks down which aligns with my expectations, I would expect it to test the lows reached back in November of 2009. If we see prices test the November lows in coming days/weeks, I expect oil, precious metals and equity prices to continue to work higher."

When I wrote my previous article I was not expecting the U.S. Dollar Index to test those lows until next week at the earliest. However, Mr. Market proved me wrong as the Dollar Index tested that area in overnight trading Thursday morning. In fact, prices actually plunged lower than the 2009 lows, which may foreshadow lower prices yet to come. The weekly chart of the Dollar Index is illustrated below:

$USD

It does not take a trained eye to see that the U.S. dollar is under attack. With the Dollar under pressure, the potential for a possible parabolic move in precious metals and oil increases. In fact, the parabolic blow off top many traders are calling for in the commodities market might come to pass if the Dollar continues to trade lower. As an example, the daily chart of silver futures reveals the massive rally that has taken place over the past few months.

$SILVER

If we do see a parabolic move in precious metals and oil followed by a sharp selloff, traders should expect precious metals and oil prices to decline rapidly. History suggests that when commodity bubbles finally burst, horrific selloffs have the tendency to take place. As an example, the weekly chart of crude oil futures below shows the nasty selloff that immediately followed the exponential rise that we witnessed in 2008.

$WTIC

Rising oil prices threaten the U.S. economic recovery tremendously. If we get a nasty selloff in the U.S. dollar, we could see precious metals and oil put in another parabolic move that leads to a topping formation. When the commodity complex finally gasps and the top is reached, an epic selloff will result. Just when the commodity bubble peaks, the U.S. dollar will likely find support and will rally as it has been under pressure for months now.

The resulting rally would cause gold, silver and oil prices to collapse. While I do not see this sequence of events unfolding currently, at some point in the future it is likely that a similar outcome will come to pass. I intend to play the short side in precious metals and oil when the time comes, but for right now as long as the U.S. dollar continues to trend lower, shorting commodities is a terrible idea.

The point of this article is not to consider shorting commodities right now as that could lead to devastating losses. The primary thrust is that at some point in the future, the commodities party will end. The bubble will burst and a nasty selloff will transpire. The bubble might burst in June when QE II ends. It might happen in May. Who knows?

It cannot be known for sure, but what is known is that history suggests that a nasty selloff will signal the end of the reflation trade and the beginning of the next leg of this bear market. We are not that far from the top, as the business cycle is nearing completion as commodity stocks are rallying which is generally indicative of late stage market cycle expansion.

We are in the late expansion stages of this bull market run and it is my opinion that if we do get the blow-off top in commodities, specifically oil, that within six to nine months of the topping formation in oil the U.S. economy will slide back into recession and the bear will begin his attack yet again. While I do not make predictions often, if and when the bear returns I will not expect the March 2009 lows to break, but I do expect to see a valuation low sometime in the next 3-5 years, if not sooner.

When I speak of valuation low, I'm focused on PE multiples, PEG ratios, Earnings multiplier, etc. The P/E earnings and multiplier will likely come into contraction in coming years and if this chain of events takes place, it will offer long-term buy-and-hold investors an unbelievable investment opportunity.

Regardless of what happens in the future, I have been involved in the recent upside move this week as my service has offered up a realized return of 12% on a RUT Calendar spread, an current unrealized gain of around 25% on a SPY Call Vertical spread and a massive 100%+ return based on risk on a GLD trade. I continue to seek out opportunities in precious metals, equities and oil going forward. The real question I would like to know is just how high will silver, gold and oil go before they top?

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JW Jones

I hold a current position in GLD and SPY.
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