Although we believed the odds were “rapidly contracting” for such an event, oil prices provided a continuing shock as a catalyst for our forecast, which claimed, “We still see at very worst, a test of the early year lows.”  That test is now in progress.  We mentioned a “peculiar” gestalt based on “hopeful waiting” that has since turned to outright fear.  The AAII sentiment readings and Investor’s Intelligence are again indicating big time fear.  As of now, with the few exceptions of active fund managers and AAPL and RIMM day traders, fear and pessimism reign supreme.  Despite the economic backdrop, this is the kind of psychology one expects at a bottom.

Our focus on the charts of Wachovia (WB) and Wamu (WM) last time out were prescient as they declined nearly 30% in only three weeks!  Both had already been decimated as the credit crisis unraveled.  While the crisis may bring additional negative developments, the decline of the last month has discounted at least some of our concerns.  At this juncture, upside potential is likely three times downside risk, so our bearish bent is diminished for the short term.  A rally should be expected soon.           

According to IRS data, 79% of all tax returns reporting capital gains were from households with less than $100,000 in income; 47% of all returns reporting capital gains were from households with incomes less than $50,000.  However, presidential candidate Senator Barack Obama has pledged to nearly double the capital gains tax from 15% to 28% as part of his "Tax Fairness for the Middle Class" plan.  Unfortunately, the past provides evidence that lower capital gains taxes encourage investment and the taking of profits but higher capital gains taxes encourage the opposite (see http://tinyurl.com/3a25pe and http://tinyurl.com/6krl4z).  Interestingly, the Clinton budget surplus was likely due to a lower capital gains tax, rather than any other factor.  Republican candidate Senator John McCain has vowed to keep the lower capital gains taxes in place.  Given the economic background, a contracting economy and a punk stock market, the very last consideration for a new Administration should be higher capital gains taxes.  Since Senator Obama is roughly 2-1 odds at this point to win the Presidential race (see www.intrade.com), we rate this circumstance as yet another potential long term negative for stocks.  The 15% capital gains tax legislation is set to expire December 31, 2010.    

Recent stats clearly illustrate that consumers are cutting back sharply on auto use.  A weekly report from MasterCard claimed Americans purchased 28% less gasoline in the week before the Memorial Day weekend as the same week one year ago.  The U.S. Department of Transportation has reported Americans are cutting driving by 4.3%.  The recent declines are the first since the oil shock of the late 1970s.  Not only is fuel demand down, supply is rising.  The Energy Department reported on June 4th that gas stockpiles rose 2.94 million barrels in the previous week, the biggest gain since February. Supplies of distillate fuel, including heating oil and diesel, climbed 2.28 million barrels, the most since last July. 

More on supply: as reported on Bloomberg, "....a 1.4 percent gasoline inventory gain to 209.1 million barrels left supplies 3.8 percent higher than during the same week last year. Stockpiles were expected to increase 825,000 barrels, according to the median of 14 estimates....Distillate inventories climbed 5.7 percent to 111.7 million barrels in the past four weeks. Supplies were expected to grow 1.68 million barrels."  As well, there is a high expectation that refineries will produce more since profit margins are huge.

The gas "crisis" of the late 1970s catalyzed a move to smaller cars with more efficient engines.  We expect the same to occur now.  Ford and General Motors reported May sales plunged 16% and 28% respectively as fuel prices drove consumers away from pickups and sport-utility vehicles. Your Editor's February 14th purchase of a 2008 Camry Hybrid has already been rewarded with efficiency as high as 43 miles per gallon, although the average is more like 35 mpg.  Honda sales rose 16% and the gas-thrifty Civic became the best-selling U.S. vehicle.  Two weeks ago, GM announced that it would close four SUV and truck plants, add a third shift to its compact and midsize sedan plants in Ohio and Michigan, and gave the go-ahead for the Chevy Volt electric hybrid to debut in 2010.  A sea change is on the horizon.  

Another important factor in demand - major airlines are cutting back their fleets.  Less planes should result in less fuel consumption.  The world's second-largest carrier UAL, is going to reduce its fleet by 70 planes, on top of 30 already taken out of service.  American Airlines previously announced they will retire 85 aircraft.  Delta is also cutting back on their fleet and will reduce its mainline fleet by 15 to 20 aircraft and its regional aircraft by 20 to 25 planes.  

Although a changed mindset by manufacturers and consumers will result in less demand, the obvious offset is that for the long term, demand will remain robust as China continues to move towards capitalism and India begins to repeat China's economic success.  Thus, we do not expect the same kind of slide in crude prices as we witnessed after the surge in the 1970s.  However, there is sufficient reason to expect a substantial price correction, a hallmark of even the strongest bull markets.  Despite the probability of an economic slowdown here at home, world wide demand should bolster price support and the downside for crude will not be long term.  The downside could easily be limited to the $100 mark and in any case, will likely be no less than $80 per barrel, a level that still exceeds the 1981 peak adjusted for inflation.  This would also take prices back to last year's still historically high levels, leaving a scenario that at least, provides some impetus for consumption and clearly, provides a continuing strong impetus for additional research into alternative energy methodologies.  Definitely not an ideal scenario, but under the circumstances, a reasonable "best case scenario."   

In our 2008 Year Ahead issue we offered 20% odds for "oil shock" and clearly, the 48% rise into the $139 per barrel peak can be categorized as "oil shock."  Although some forecasts now extend as high as $250 per barrel by next year (see http://tinyurl.com/6ommll), we just do not see that happening.  Once the 2008 Olympics come to a close, even the great Chinese engine of growth will lose an important catalyst.  On the domestic front, credit problems and inflation are not going to easily go away, thus the probabilities favor at best, reduced growth in demand for goods and services worldwide.  Of course, we cannot rule out a modest spike beyond the recent high but given the already visible impact of $139 oil, the odds now appear substantial for a pullback/correction in price.  

ABOUT ALAN M. NEWMAN

Alan M. Newman has been the Editor of CROSSCURRENTS since the first issue was published in May of 1990. Mr. Newman is also a member of the Market Technician's Association and has been widely quoted for years by the financial press, media, and other newsletters and has written articles for BARRON'S.

The newsletter is published roughly every three weeks and focuses on economic and stock market commentary, often covering controversial subjects. Several proprietary technical indicators are usually featured in every issue accompanied by current interpretation.  Broad samples of our work can be viewed at http://www.cross-currents.net/. 

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