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Week Ahead: Oil Gusher Could Swamp Stocks

Gushing oil prices could swamp stocks in the week ahead, and even if crude pulls back, expect volatility.

Big themes for the week are about inflation and the consumer. Fed officials, including Fed Chairman Ben Bernanke, speak at a conference on inflation at the beginning of the week. The big market forces to watch are also about inflation—oil and the dollar. Then there's a consumer inflation data due out Friday, and if any European Central Bank officials speak, you know they'll talk about inflation.

Oil's choke hold on the economy though is the hot topic, and some traders expect to see crude spike to the $150 level before it reverses.

Oil shot up to $139.12 in Friday trading, a record jump of $11.19 per barrel. Oil was 8.8 percent higher for the week and started its climb after European Central Bankers Thursday indicated they were ready to start raising interest rates to fight inflation, a comment that instantly weakened the dollar.

The stock market ignored a big move in oil Thursday but on Friday, it went into a panicky downhill spiral as the steep move in crude coincided with a disappointing employment report. "None of this is a good sign," said veteran stock trader Art Cashin. He said the S&P 500 broke through a critical support level of 1370 and that could invite a retest of January and March lows.

Wall Street Roller Coaster

"You're going to come in next week, and there's going to be a sign that says you must be taller than four feet to get on this ride, and you must keep your seat belt on at all times," said Cashin, UBS director of floor operations.

Earlier in the week, credit worries took over as the top brick in the market's wall of worry, temporarily knocking aside high oil prices and inflation phobia. Those concerns were trumped by oil Friday, but the financials were the big losers for the week, down more than 6 percent.

J.P. Morgan chief investment strategist Thomas Lee has told us he thinks an oil price of $130 per barrel is a flash point for stocks. "We're still watching the situation carefully, but I do think without question because we're still in June and oil is at $130, that I think it's important for investors to think about how earnings for corporate America will be affected by high oil prices," he said.

"I actually think we're going to want to make some adjustments to our earnings estimates," he said.

Market Mayhem

The Dow lost 3.4 percent or 428 points this past week, 394 of them Friday. The S&P was down 2.8 percent for the week at 1360, and the Nasdaq wiped off 1.9 percent to finish at 2474.

The dollar fell 1.3 percent against the euro this past week, but it took a pounding in the final two days of the week, losing more than 2 percent. It has been higher earlier in the week, bolstered by supportive comments from Bernanke. Buying in Treasurys pushed the yield on the 10-year to 3.936 percent and the two year was at 2.398 percent.

Econorama

The Fed's beige book Wednesday, May retail sales and consumer inflation data are the big items to watch., but there's a long list of data points in the week ahead. Pending home sales are reported Monday at 10 a.m. International trade is Tuesday at 8:30 a.m., while the Fed releases its beige book on the economy Wednesday at 2 p.m. Oil inventory data is released Wednesday morning at 10:35 a.m.

Retail sales for May are reported Thursday at 8:30 a.m. and will be an important look at consumer spending. The import and export prices are reported Thursday, as are business inventories. On Friday, the CPI is reported at 8:30 a.m. and consumer sentiment is released at 10 a.m.

What to Watch

Technology stocks have been on a roll, and in fact are the second best performing S&P sector for the past three months, with a more than 10 percent gain. This week the focus will be on Apple and its new 3G iPhone, expected to be rolled out at the Apple developers conference Monday.

On the political front, N.Y. Sen. Hillary Clinton is expected to drop out of the Democratic race for president. The contest is now between Ill. Sen. Barack Obama and Republican Sen. John McCain of Arizona.

Fed-a-Rama

Fed Chairman Ben Bernanke speaks Monday night at the Boston Fed's 53rd Economic Conference on "Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective." That's really the title, and you can see that in this environment we'll be all ears.

Bernanke, who made lots of headlines worrying about inflation in the past week, speaks at 8:15 p.m. His topic is: "Outstanding issues in the analysis of inflation" and he does not answer questions at the Chatham, Mass. event. On Tuesday morning, Fed Governor Frederic Mishkin speaks at 8:30 a.m. at the Boston Fed conference and his topic is forecasting inflation. On Wednesday, Fed Vice chairman Donald Kohn is at the Boston conference and he speaks on lessons for central bankers at 11:30 a.m.

Dallas Fed President Richard Fisher will be on "Power Lunch" Monday and we will be watching his comments closely.

On Monday, New York Fed President Timothy Geithner speaks at midday in New York. Fed Governor Randall Kroszner speaks Wednesday at 12:15 p.m. on consumer credit markets at the Cleveland Fed. Bernanke attends a ribbon cutting ceremony and dedication of the Federal Reserve Bank of Kansas City Thursday at 11:30 a.m. He makes brief comments and does not take questions.

So What to Do Now?

What to Do

I spoke with Jim Paulsen, chief investment strategist at Wells Capital Management, on Thursday before oil prices started ripping higher. "We probably needed a sell off after we had a huge run off the March lows. What has caused it is encouraging. In other words, this has come in the last couple of weeks when the economic reports couldn't have been better. Day after day, they outpaced expectations. The market is selling off because they're not watching that. They got refocused into "Lehman's next! phobia."

Paulsen said he thinks oil will come down in price, and he compared the current period to the 1970s when oil spiked. "Every other oil crisis was associated with rising bond yields.. a rise in the dollar. Not only were energy prices roaring, but core inflation was roaring too. The crisis is the same in oil but is the opposite everywhere else," he said.

In making his case that oil is overpriced, Paulsen pointed to the ratio between crude prices and a Goldman Sachs nonenergy commodities prices index. "Oil between 1975 and 2005 traded between two and six times non energy commodities prices. Right now it trades at 10." He said if it fell back to that ratio, oil would trade at $77. "This is nothing more than dotcomism. The technology story was there for years, but it wasn't for 10 years in that the stock price story became explosive. The oil story's been there for how long, but it's only recently that its gotten out of control," he said. "How many portfolios are overweighted oil?"

Paulsen, obviously , isn't keen on energy stocks but he does like tech and industrials and he is slightly overweight financials. On financials, "there's such high levels of pessimism in these values that a lot could go wrong and there's still a value case to be made," he said, adding the group may still have issues later on.

He said homebuilders and financials have been closely related in the stock market but, while the builders put in a relative bottom, financials have not.

Paulsen said he's changed his view on foreign markets. "We'd been overweight international since '02. We still are but we are no longer overweight developed international. I think the U.S. market will outperform the developed markets. Both because we entered the slowdown before them and we're going to come out of it before them. I think you're going to do better staying home .. We still are overweight the emerging world stock markets," he said

Paulsen said he thinks the market should attract money this summer. There should be some momentum from the impact of Washington's policy moves, and there clearly would be if oil fell. "We've got low- to mid-teen multiples on one year forward earnings which is pretty good....I think the value is good, the pessimism is high, the idle liquid assets is high, and we're likely to have an economy that outpaces expectations. I think there's big upside for the stock market. I think we have a shot of putting on a couple hundred points, maybe looking at the 1600 level" on the S&P, he said.

"I would argue we've been breaking out since the March lows. I'm an investor, not a trader so I tend not to sweat all the in betweens here. To take a general stand on some of these bigger bottom and tops is what I tend to do. I still think there's a lot of evidence we're going higher as opposed to breaking down," he said.

"You've got a lot of things beaten up in this crisis. I'm more incline to retailers and consumer discretionary than the financials because I think there's less balance sheet risk," he said.

"I think the idea that the consumer is dead is way overblown.. I think people are misinterpreting a change in the composition of U.S. growth," he said. Paulsen said the consumer has largely been driving the economy but the increase in growth from trade is changing the mix in the GDP "I agree that consumption is going to grow more slowly and that will mean issues for Starbucks and banks."

But Paulsen thinks the trend is longer term and the impact of trade related growth will be a positive that also helps consumption.

Questions? Comments? marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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