In yesterday's WSW Power Investor Pre-Market Bulletin I made note of the fact that the stock market appears increasingly vulnerable. Weekly indicators are signalling that it is totally overbought and according to Investors Intelligence there are now as many newsletter writers proclaiming themselves stock market bulls as there were back in April, right before the market's last big correction. Jim Cramer is now telling people to jump into tech stocks while CNBC talking heads are saying that energy is in a bear market.

There has been a strong correlation in the past few years of the DOW rising when oil falls and the DOW falling when oil goes up. Well oil is now oversold on a weekly chart just as the DOW and Nasdaq are overbought. All signs point to a rally in commodities. If the pattern of the last few years holds then you can expect the broad market to weaken as commodities go up.

The market is now being driven by pure momentum institutional traders who jump into the flavor of the moment. They got into natural resource stocks late to the game last Spring and have been selling out of those positions the past six weeks to buy the seemingly red hot DOW.

As Bradley Willett of Fallstreet.com writes:

"The 1990s stock bull lasted longer than most thought possible because there was a constant flow of new money entering the markets and chasing stocks higher. In the context of a financial world awash in excess liquidity, the Dow’s record rally today is, in part, being fueled by real estate/commodities investors seeking refuge in stocks."

"Money that a year ago would have been invested in Miami condos and six months ago would have been invested in crude oil futures is now looking for a home� John Skjervem, Northern Trust (AP)"

"While large capital movements between asset classes is not always a red flag, there is cause for concern if today’s movements are being made by investors and managers whose investment horizons stretch to next weeks Fed meeting, or next months election. To be sure, whereas a long-term bull market can engender a ‘buy the dips’ mentality among market participants, a rotationally driven rally can sometimes create the conditions that make sharp market declines possible. For example, in 2000 when money temporarily rotated out of ‘new economy’ stocks and into ‘old economy’ stalwarts many analysts applauded the safety that traditional blue chips offered the investor compared to tech. In hindsight, market rotation in 2000 was simply a sign that the bull market was exhausted."

"Question is, does rotation in the marketplace today mark the end of the good times? Although a difficult question to answer in a timely manner, that large cap U.S. stocks are being touted for their ‘safe’ qualities today is eerily familiar to rational given to buy blue chips in 2000/01. For that matter, that JNJ – a recession resistant company - is the top choice among stock newsletters at a time when the Dow is supposedly kicking off another bull leg is, well, just plane eerie."

"Of equal concern to the rotational forces at work in the markets is the fact that - based upon P/E disparities - many Dow components are already pricing in a peak to the corporate earnings cycle. With economists (Bloomberg) recently cutting GDP estimates to 2.6% in 2007 – the weakest since 2003 – labor costs rising, and CEO confidence slumping to a 5-year low (conference board), evidence is mounting that the historic streak of double digit increases in U.S. corporate earnings is in jeopardy."

"But alas, we are told not to fear: the Dow is relatively undervalued compared to other markets both global and domestic (i.e. small/mid caps), big capital shifts simply prove that large cap U.S. stocks have been out of favor far too long, and the earnings hawks are wrong again. As for the U.S. economy, it is growing! and as one M&A analyst recently put it, “Low interest rates mean “it's cheaper to borrow money than go bankrupt��. Growth today may well cost the U.S. consumer dearly tomorrow, but who really cares…"

"In summary, although July 14, 2006 has definitely usurped May 11, 2006 as the most important ‘transition’ day this year, it is nonetheless difficult to conclude that this transition was into a sustainable stock market bull. The Dow’s rally may simply be the handiwork of the hot money crowd in search of a temporarily sanctuary. That this crowd previously parked capital in skyrocketing real estate, natural gas, and (still) perfectly priced emerging markets doesn’t worry the Dow cheerleaders. It should."

---What happened on July 14? It was the day that oil topped out. It appears that this week will be just as noteworthy - with the strong likelihood that oil is about to begin a sustainable rally just as gold appears to rally ahead of it. Gold usually leads the rest of the commodities market.

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