For the past eight weeks, stocks have been climbing without a meaningful pause. With a brief respite in November 2010, stocks have generally been at overbought levels since October. Under normal circumstances, when stocks reach these levels (as measured by several technical indicators) a correction follows. Because no correction has occurred this time, the obvious question is: why?

Back in October we were warning investors that because stocks were overextended, investors needed to exercise caution because the risk of a downturn was high. A correction followed in November, but it turned out to be a minor short-term slide rather than the more significant intermediate-term drop we anticipated. Since the beginning of December 2010, stocks have risen sharply and are now again at unusually extended levels. A downturn is past due, but if and when it occurs, will it be significant or just a three-week blip like we saw in November?

The chart below provided a clearer illustration of the situation. It shows the daily price movements of the New York Stock Exchange Composite over the past six months. The bottom three sections of the chart show three separate technical indicators: a moving average convergence divergence (MACD), a stochastic oscillator, and a relative strength index (RSI). All three are signaling that NYSE momentum is faltering.

But looking back over the past six months, it is plain to see that all three of these indicators have been in a similar situation recently and no significant correction has occurred.

Several negative factors still exist that have the potential to derail this bullish trend. Fundamentally, the major problem still getting lots of attention is unemployment. U.S. jobless rates remain at historically high levels. While the monthly rate has fallen, much of the decline can be attributed to people dropping off the list because they have given up looking for work or they have exceeded the allowable term for jobless benefits. In addition lots of Americans are working reduced hours, for reduced pay and fewer benefits.

So far political leaders in Washington D.C. have done nothing substantive to reduce the U.S. budget deficit. Most economists agree that long term the growing debt poses a significant threat to the economy.

Of course there is also the unsettled situation in the Middle East. Demonstrations in Egypt continue. While the United States and most of its allies would like to see a democratic government in Egypt, there is the possibility that the Muslim Brotherhood or some other Islamic group could gain control. Such a scenario would have the potential to destabilize the fragile political balance of the region.

I could list additional problems and threats. The point is that there are plenty of reasons that could negatively impact the markets. But in spite of these factors, stocks continue to rise. For now, stocks remain in a strong upward trend and until something changes, it seems likely that the trend will continue.

Corporate earnings rather then economic fundamentals seem to be the driving force for the markets right now. As long as companies are making money—even if they aren’t doing a lot of hiring or expansion—expect to see this trend continue.
Flint Stephens

Scenes of unrest in Egypt have dominated news broadcasts for the past week. When the riots began, the U.S. stock market responded with a sharp one-day drop on Jan. 28. But major indices quickly regained the lost ground and more during this week’s trading. No doubt many investors are wondering why the market has not shown more reaction to this turmoil.

The lack of a major pullback is a sign of the strength in this bull market. The situation in Egypt provided a perfect opportunity for stocks to stage a sharp sell off. The fact that they have not done so should probably be viewed as a favorable indication that even though stocks have been overbought for some time, there still is room for them to sustain this advance. Wall Street does not like uncertainty and there is currently plenty of that in Egypt. But so far it appears that the situation will have little direct impact in the U.S.

There are a couple of ways that the situation in Egypt could disrupt the U.S. markets and economy. The primary factor is oil. Compared to many other nations in the Middle Eastern region, Egypt plays a fairly minor role in the global energy sector. Egypt still controls the Suez Canal, which used to be a major route for oil transportation. But today only about 2% of the world oil supply goes through the canal. During past conflicts, the canal was often mined or even captured by Israel. As a result, the oil industry largely switched to supertankers that bypass the canal or to oil pipelines.

One of these pipelines, the Suez-Mediterranean (SUMED) oil pipeline passes through Egypt but has not been a target of protestors. According to STRATFOR Global Intelligence, “Egypt, unlike Iraq and Nigeria, does not have a history of pipeline attacks. [While] it could, at least theoretically, be targeted by those upset with the regime. SUMED was built so that Egypt could still profit from the Middle East-Europe oil traffic that now largely avoids the canal. The pipeline is capable of handling 2.3 million barrels per day of throughput, but on the average day transits less than half that amount. That might sound like a fair amount of oil — and it is — but this is simply the transit of oil that could make it to its destination by other means, not actual production that could be threatened.”

The real threat from the crises in Egypt comes from a general destabilization of the situation in the Middle East. The 1979 Egypt-Israel Peace Treaty has been perhaps the most important factor in maintaining peace between Israel and the Arab nations. As the whole world knows, that peace is tenuous at best. Egypt has also been the United States’ strongest ally among the Arab nations.  If the balance of power in Egypt shifts against Israel, then the entire region and a significant portion of the global energy supply becomes at risk.

Under the best of circumstances, the price of oil can be highly volatile. And because the demand for oil is so pervasive across all sectors of U.S. business and for individuals, spikes in the price of oil usually send shock waves through the U.S. economy.

Below are two charts showing the price movements of United States Oil Fund (USO). The first shows price movements over the past year and the second includes the past four years. In the first chart I’ve highlighted a sharp 24% decline in the price of oil that occurred in May 2010. This provides a good illustration of just how quickly oil prices can move. In the second chart I highlighted the huge run-up in oil that began in 2007 and continued through much of 2008 and its subsequent decline.

Oil prices have generally drifted upward since August 2010, but they remain well below the levels that preceded the sharp advance in 2007. While problems with sub-prime mortgage loans get most of the blame for the ongoing U.S. economic woes, rising oil prices might have been the proverbial straw that broke the camel’s back and plunged the U.S. into the deepest economic slump since the Great Depression. There is also little doubt that the fall in oil prices that began in the late summer of 2008 significantly contributed to the economy being able to regain some positive economic footing.

So while the current conflict and chaos in Egypt makes for interesting news footage, for the time being it seems doubtful that it will have any immediate impact on the U.S. economy. But investors should watch closely when the transition to a new government takes place. If the conflict and unrest spreads beyond Egypt and begins to have an impact on world oil prices, then U.S. investors will have something to worry about.
Flint Stephens