Trader’s Narrative

Here’s a review of the previous post on the energy sector:

On September 18th, 2008 I wrote that the energy sector presents a bounce opportunity. As the chart of the S&P Energy Select Sector SPDR ETF (XLE) shows, the bounce was a feeble one which failed within a few days:

But the rational for it remains. The bullish percent index for the energy sector is now the lowest for any sector in the market. The only other sector close to scraping the bottom is the industrials at 3.57%.

What is very strange is seeing the energy sector and the transports in alignment. I mentioned the oversold transportation sector earlier this morning. So what we may end up seeing is the strange case where both of them rally together.

Of course, sectors don’t just rally because they are oversold. Although it is rare, they can and have gotten down to zero. We are approaching DEFCON 2 - if the sentiment overview is anything to go by. And although it sounds absolutely crazy, now is not the time to be selling but rather coming up with a game plan to go long.

The days ahead will demonstrate for traders why being disciplined in respecting stop-losses is more valuable than having the conviction behind a position.

Oil has corrected sharply. And so have the majority of commodity markets. But in contrast to the financial sector which has the news in a headlock, the energy sector is not only being mostly ignored, it actually presents exhaustive selling and is setting up a pattern which has seen it bounce higher.

This is a chart of the bullish percent index for the S&P Energy Sector:

After yesterday’s close the bullish percent closed up but on Tuesday, there were less than 6% of the component stock showing a buy signal according to point and figure charting. This is a sign of extreme exhaustion within the group and as you can see, it has presaged some important inflection points. The lower the bullish percent, the more powerful wave of selling that hit the sector. If anything, right now I would play this group as a whole (through an ETF like XLE) or components like Valero (VLO), Chevron (CVX) and Halliburton (HAL) for a bounce.

The last time this happened was in January 2008 when immediately after, the whole sector bounced back with a vengeance. Of course, in these situations, one has to be mindful whether it is more of the same or a whole new ball game. That is to say, if we are seeing yet another correction within a secular bull market, or whether the major trend has changed and the “oil bubble” has been pricked.

But I would argue that at this junction, if any sector is in “washout” mode, it is the energy sector and not the beleaguered financials. At least they aren’t there quite yet - although there is a lot of wailing and gnashing of teeth.

Continuing to look at the energy sector, here is another chart that shows some interesting technical characteristics:

A shallow angle of ascent provides for an uptrend’s longevity. But as it ramps higher at a steeper and steeper slope, then the trend is either about to end or reverse.

You can see in the case of S&P Oil & Gas Exploration SPDR (XOP) ETF that the uptrend has changed slope three times. Each time becoming steeper. According to traditional technical analysis this is a sign of exhaustion. No trend can sustain itself for much longer once it has intensified three times.

Another important element is the formation of a shooting star candlestick formation on the weekly chart. This is another sign of impending trend exhaustion. It is significant only after an uptrend. You can find others on the chart, for example the first week of November 2007.

Think of shooting stars as inverted hammer candlesticks. Just as hammers are bullish when they occur after a downtrend, so are shooting stars bearish after an uptrend.

Today’s market got spooked in the morning with the release of consumer price index data showing a more than expected 0.4% rise for January, Almost all components, including energy, contributing to the increase.

Yesterday crude oil futures (March 08) jumped $4.51 to close at $100.01 and today they reached $100.74 - so what better time to look back at my previous comments about Texas tea.

Last December I wrote that I saw a double top in crude oil, here’s how it has fared since:

The $100/barrel level is proving to be mighty resistance for crude but the more prices butt heads against it, the more fragile that glass ceiling will become.

This is the fourth time that the bulls have attempted to breakthrough but it is the highest they have been able to push prices so far. So the double top I thought I spied last year has now become a potential quadruple top.

When the market was going to hell in a hand basket in the middle of January, I didn’t write anything specifically about energy or oil stocks but if you were reading the blog then, you couldn’t have missed the unmistakable bullish bias.

During the same time, the bullish percent index for the energy sector reached a low of 7.06% !! To put that in perspective, we’d have to go back to the bear market bottom of 2002 to find a lower bullish percent reading. Since it was a full market meltdown, the same was happening for almost all sectors.

In January 2008, as oil stocks were topping, the bullish percent reached a high of 75.29%. In comparison, the current reading is 71.76%, definitely getting up there but still not extremely high. Which is why I think that if you scooped up cheap shares in the January fire sale, here would be a good time to start offloading them.

Crude may breakthrough the magical $100 barrier but right now there is too much frenzied attention around it and it has climbed to far too fast to continue at the same pace without first catching its breath.

If all this talk about “bullish percent this” and “bullish percent that” in confusing you, read:
How To Time the Market With Bullish Percent Charts

With increased chatter that a US attack on Iran is imminent, oil has been on a tear. And today’s release of government data showing that supplies dropped by 7 M barrels propelled the futures above $80 on the Merc.

In case you’re keeping track, that is the highest price that oil has ever traded (for the one month out contract).

If there is an attack on Iran, it will not be an occupation but similar to the “shock and awe” we witnessed on our TV screens at the onset of the Iraq war. However, attacking Iran will have totally different consequences for the oil market.

That’s because of a geological bottleneck called the Straight of Hormuz. A war would in effect close this “valve” and shut off access to the Persian Gulf for oil tankers.

I have no idea whether war is coming or not. The only thing in my power is to estimate the probable consequences. It isn’t difficult to imagine oil reaching +$100/bl. Which will send oil stocks like Halliburton (HAL), Valero (VLO), Diamond Offshore (DO) and everyone’s favourite: Energy Select Sector SPDR ETF (XLE) to the stratosphere.

In August I wrote about a rare occurrence in the energy sector. The bullish percent index reached an unheard of 13.92% on August 17th, 2007. The BP index had only only reached below 20% 8 times before in the past 10+ years. Each time, as you’ve guessed, was an amazing time to load up on oil stocks.