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It's put-up or shut-up time for stocks and oil

Stocks gave a little back on Tuesday after Monday's impressive run higher.

The drag was crude oil plummeting again after Saudi Arabia's oil minister reiterated that any production deal would involve a freeze at current supply levels, not a cut to drop output. He also thundered that high-cost producers (looking at U.S. shale producers) must lower costs or liquidate. And the Iranians remain upset about the idea of a production freeze as they ramp up output to pre-sanctions levels.

As a result, both large-cap stocks and crude oil futures have reached critical decision levels. Back on Feb. 11, declines into the abyss for both looked likely as prices breached their mid-January lows. The bulls have since battled back, returning both equities and energy prices to their January highs.

Will we see an upside breakout? If so, both stocks and oil will need to participate.

That's because the two have been moving in lockstep lately as the fortunes of everything from corporate earnings growth to the likelihood of additional Federal Reserve interest rate hikes this year depends on how crude oil moves. According to Bloomberg, the correlation (or statistical link) between stocks and oil climbed to a 15-year high on Jan. 21 to 0.96 (a reading of 1.0 means the two are in perfect lockstep).

Historically, high correlations across asset classes have marked periods of market stress. During the 2008-2009 financial crisis, when portfolio diversification benefits were most needed, tight correlations across sector groups and asset classes meant investors were often at greater risk than they realized.


The correlation has since declined slightly, to 0.8 as of late last week, as the situation has stabilized and investors have focused on other dynamics. If stocks and oil and break up and over their resistance levels -- near $34-a-barrel for oil and 1,950 on the S&P 500 (chart above) -- the correlation should continue to fall as markets return to normal.

For profit-seekers with a positive outlook, Ed Yardeni of Yardeni Research noted that diversified metals and mining stocks have far and away been the leaders, with a gain of more than 62 percent between Feb. 11 and Feb. 22. Also near the top are aluminum stocks like Alcoa (AA).

These have been some of the most beaten-down shares over the past two years on a combination of falling commodity prices and large debt loads.

Many, such as Freeport McMoRan (FCX), are focusing on balance-sheet restructuring, a sign management has accepted the current environment of constrained revenues and is working to make the best of it. That's bringing buyers back into the sector on anticipation of a possible rebound in global economic growth spurred by fresh policy accommodation by the world's major central banks.

As for crude oil, the bulls are apparently being encouraged by an ongoing collapse in U.S. drilling rig activity, which fell another 26 units to 413 last week -- the ninth straight weekly decline. The rig count is now at the lowest level since December 2009. Although the count is down 79 percent from its 2014 high, U.S. oil production remains steady as companies focus on more productive wells.

Still, with fewer rigs active, it will likely tighten the noose on weaker, more leveraged producers and drive many into default.

Yardeni also noted we're seeing a demand-side response to lower energy prices. He estimates that U.S. consumers are enjoying an oil windfall of up to $500 billion even as they hit the pump more often. Oil demand in China and India just hit fresh record highs.

Will all of this be enough to push stocks and crude oil out of their funk to challenge highs not seen since November and December? We'll soon find out. But large-cap stocks have now gone nine months without setting a new record high -- casting doubt over the vitality of a bull market now in its seventh year.

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