Soon, the Tail will Stop Wagging the Dog: ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO)

January 28, 2016, 12:40 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

Soon, the Tail will stop wagging the Dog.

I am speaking directly to oil and the influence oil has had on the perception of risk in the stock market has been tangible, but those days are numbered, and may actually already be behind us.  In my point of view, oil and the stock market are very likely to move to the beat of a different drum in the months ahead.

When markets fall investors love to point the finger at something, they almost feel like they have to, especially when the declines are happening due to fundamental factors that they may not want to admit.  For example, we may have heard 'It was because of oil, or Apple, or China' recently, and sure those were all factors, but healthy markets can withstand stuff like that; ours cannot.

The attention of this piece in on oil and specifically on the influence oil price declines have seemingly had on the market, but although there is a technical parallel I have maintained that they were not as in tandem under the surface.  Oil was falling for one reason, and the market was falling for another.

More specifically, oil was falling due to supply concerns and less robust demand from China too, and OPEC's stance was a direct influence on those declines.  They happened at the same time valuation risks in the market were sky high, after the market failed to rally at the end of the year and broke a historical cycle of being up in the third year of every second presidential term, and after margin debt was pressed to all time highs and the cash to margin debt ratio depleted to all time lows. 

The Stock Market was falling due to liquidity and valuation concerns, it still is and rightfully so, while oil was falling due to a tough nosed policy stance by OPEC and the supply problems that stemmed.  Now something may be changing.

Although nothing is official, Wall Street is privy to information that now suggests Russia and OPEC will engage in talks in February and they could cut production by 5%.  If they do this it would translate into a 2 million barrel per day reduction, which would turn the tides on the supply-side problem.  Our estimates suggest that about 1.5 million barrels in excess are produced daily at this time.

A meeting between Russia and OPEC would be considered an emergency meeting, and the price of oil surged in the months that followed past emergency meetings.  That suggests the same could happen again, but we believe it would be much more than that too.

Our outlook is for a triple from current oil prices over the coming 12 to 18 months.

However, in consideration of the market, our outlook is that the risk of a market crash remains real too.  This will be true regardless of what happens to oil, and especially if oil prices increase because of changes to the supply side alone without any economic improvements that might improve demand.  In that light, the risks in the market would stay while oil prices moved up.  In fact, risks could actually increase if gasoline prices spike along with higher oil prices and the consumer starts pulling back in a much more material way.

That is exactly what we expect, and the Tail that seems to have been wagging the Dog according to some, will no longer be doing that.  The Tail (oil prices) will stop wagging the Dog (the market) and it probably already has, but probably never was. 

Certainly, there will be some continued correlations, that's normal, but we will be able to observe material divergences in the chart patterns soon.  Monitor ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO) and Proshares Trust II (NYSEARCA:SCO) in conjunction with ProShares Ultra QQQ (ETF) (NYSEARCA:QLD) and ProShares UltraShort QQQ (ETF) (NYSEARCA:QID) to keep tabs on this expected divergence. 

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