I’ve been thinking about the drop in [[USO]] and the rise in the [[INDU]] and over and over again as I drink my morning coffee and peruse the news for the last month or so it’s been this meme:

More advisers in the latest survey said they foresee a decline in energy prices

And to be fair, for most of us this is a good thing. Lower fuel costs (it’s been as high as $1.47/litre around here lately) help getting the groceries (with their own baked in fuel costs) when one can’t really afford to fly (another source of baked in fuel pricing) to anywhere nice for an August get away.

I am sure everyone here is aware of the other active meme, which is that (to wit) the money left oil to go back to equities when the USD began gathering steam.

It seems that lower prices in oil means that the stock market is going up no?

Todd Harrison over at Minyanville begs to differ:

Pundits are quick to point to the decline in Texas Tea as the recent upside equity catalyst but few have discussed the demand destruction that is manifesting as a function of slowing global growth.

Looking back, the correlation between the S&P and crude oil is –0.041 over the last ten years.

Note: “correlation” means that there is a connection between two items on two lists: a & b. The “a” here is Oil and the “b” here is equities.

I thought I would investigate that and here is what that looks like for the last twelve months:

In other words: the meme is meaningless.

Todd again says:

The government created massive money supply on the back of the tech bubble to keep balls in the air and bubbles afloat. That crushed the value of the greenback and jacked asset classes—including crude—across the board

In other words: a strong dollar is a bear flag, not a bull flag. It’s no wonder that the Bulls got strong armed yesterday. The very underpinning of the rally after the last bubble was the same thing that drove banks to a frenzy of loan making.

And now it’s going away.

But as Todd notes in his article, just by knowing these facts one can get ready for the counter-counter trend rally.

Howzit Huh?

The current meme is that as long as [[USO]] slinks lower, then one should jump back into the market. Usually with the same old wrong idea that the ‘leaders from before will be the leaders anew’ (which is bunk as well but anyways) and generally when there is a correction – there is a near panic wave of selling.

The real counter-counter trend would be to set expectations (probably through options or ETFs to limit exposure) in such a way that at some point there is going to be a real counter trend where both the Financials & the Black Gold rally at the same time.

Anyone caught in pair trading of those two when that trade happens will become the traders equivalent of the castrato and no one really wants to be around on that end of the trade.

However, the other option is a massive drop in both markets and commodities. Again, as with an upside move – this can cause problems to one’s self image and bank account.

But wait, there’s more:

Former IMF chief economist Kenneth Rogoff was speaking in Singapore on Tuesday last and the Financial Times blog has some choice bits:

The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say ‘the worst is to come…

We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one, one of the big investment banks or big banks…

We have to see more consolidation in the financial sector before this is over…Probably Fannie Mae and Freddie Mac — despite what U.S. Treasury Secretary Hank Paulson said — these giant mortgage guarantee agencies are not going to exist in their present form in a few years.

The Take Away

Remembering Taleb’s Axiom (The market takes the path to cause the most pain to the most investors) I am thinking towards hedges in both ultralong and ultrashort both Financials and Commodities. While I don’t expect a Black Swan, I think there are far too many commentators and investors who are getting the goofy idea that the ‘worst is about over’.

A reasonable option would be to buy options on both ends of the 3SD (SD = standard deviation) for both groups so that if they expire, the loss is minimized.

Much as central banks around the world are desperate to contain the swings (especially in localities where elections are impending) the simple fact of the matter is that there are still a few curve balls left for 2008.

The ThemeSong