Thursday Look Ahead: Stock Market's Bull Is Hostage to Oil Prices

Now that the much-anticipated pullback has arrived, traders are debating how low the skittish stock market can go. But one thing's for sure: The answer to that question will have a lot to do with oil.

The Dow slumped 107, or 0.9 percent to 12,105, taking it down 2.3 percent in two days. The S&P 500 lost another 0.5 percent Wednesday and is is down 2.7 percent at 1307 in the same period. The Nasdaq lost 1.2 percent to 2722, making it the biggest loser of the three with a nearly 4 percent decline in two days.

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Demonstrators hold up a banner featuring Libyan leader Moamer Kadhafi reading 'Kadhafi is a murderer' as they stage a protest outside the Libyan embassy in Istanbul on February 21, 2011

Many analysts and traders believed a shallow sell off was on the horizon before news from Libya began to jar markets, and oil spiked to the $100 level. Now, the question is whether unrest in the region will spread to other oil producers, specifically the top producer Saudi Arabia, or end with Libya, which produces 2 percent of the world's oil.

Oil is the wild card for stocks, and it sent a shudder through the market as it touched $100 per barrel Wednesday, for the first time since 2008. The question now is will it continue to rise or remain elevated for a sustained period, a combination which would be a problem for the economic recovery. West Texas Intermediate crude for April delivery climbed $2.68 or 2.88 percent to $98.10 per barrel.

Focus Thursday will swing back to the U.S. economy briefly, as weekly jobless claims and durable goods are reported at 8:30 a.m. There are several major earnings, including General Motors , Target and Newmont Mining .

Markets Mayhem

As stocks sold off Wednesday, the VIX, the CBOE's volatility index and a measure of market fear, gained another 6 percent to 22.13, on top of Tuesday's 26 percent move.

Patrick Kernan, who trades S&P 500 options at the CBOE, said investors are suddenly very interested in buying protection and are paying up for it. "The price for an out-of-the-money put, relative to an equidistant out-of-the-money call has increased almost 30 percent in the last two days," said Kernan, a principle with Cardinal Capital.

"From an investor standpoint, people might not necessarily believe we're going to have any kind of serious tank in the market, but what they are willing to do right now is they are willing to pay a lot more for that protection than they were even two days ago," he said.

Kernan said even if the stock market stabilizes, he expects the VIX to stay somewhat elevated. At 22.13, it implies the possibility of a daily move of 1.4 percent in the S&P 500. If the market had sold off without the issues in the Middle East, the VIX would not be at this level. "It measures uncertainty and that's what it's doing," he said.

Brown Brothers Harriman market strategist Andrew Burkly thinks stocks could be heading for a 10 percent correction and the bottom of the current rout could be as low as 1200, about 100 S&P points below Wednesday's closing level.

But Burkly has also not been one of the more bullish strategists on the street, and his year-end target is 1350. He had said in an interview last month that he expected a fairly sizeable sell off, and it was likely the S&P would trade on both sides of 1300 several times this year.

"It definitely provides a reason for a very extended market to have a well-deserved pull back here. I don't think it's going to have a lasting impact on the underlying economic recovery," he said, adding the hit to GDP will depend on how high oil goes and for how long. He said rising oil prices may shave a few tenths off GDP.

"I don't see this as a major turning point. I do view this as a viable set back. At the same time, I don't think it's going to be one or two days. I think it's going to be measured in months, and it will be a one or two month event," he said.

"I also don't think we go straight down from here. It will be kind of back and forth," he said.

Burkly also said a favorite overweight has been and will continue to be the energy sector. Energy was the only S&P sector to gain Wednesday, up nearly 2 percent, while industrials were the worst performers, down 1.8 percent, followed by consumer discretionary shares, off 1.5 percent.

"If it's a decline that's triggered by energy, energy will continue to do well. One of the things we like is the earnings revision pattern. It's one of the best in the market. It was kind of a laggard in earnings revisions last year, and it's now catching momentum," he said.

Energy stocks also rise relative to oil because of their high correlation, he said. Burkly said year-over-year, the correlation was 70 percent, while for consumer discretionary stocks, the correlation to rising crude was negative 30 percent.

GM auto dealership with sign.

"Energy is the culprit, but also the beneficiary," he said. In the 2008 oil run up, energy stocks were also winners. "Energy was the clear leadership throughout there, until it got to the point where oil prices were at a tipping point for the economy and then they don't do well."

Exxon, Chevron, ConocoPhillips, Apache, Halliburton were all higher Wednesday. One trader said plenty of investors were taking profits out of the sector, particularly in the majors, but they were still loading up on drillers.

What to Watch

In addition to jobless claims and durable goods, new home sales and the FHFA home price data are released at 10 a.m..

The Treasury auctions $29 billion in 7-year notes at 1 p.m.

St Louis Fed President James Bullard speaks at 8:30 a.m. on the outlook for monetary policy.

In addition to looking for GM earnings, investors will watch results from Allianz, Canadian Imperial Bank, Foster Wheeler, CMS Energy, El Paso, KBR, Kohl's , Mylan Labs, Royal Bank of Scotland, Safeway, Sears Holdings, and Imax.

Salesforce.com, Autodesk, First Solar and Gap report after the bell.

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