Trader’s Narrative

Crude oil prices have dropped more than 70% from their top in the summer. It is almost ancient history to think of a time when people were running around in panic that the end of oil was upon us. Peak oil theorists, or POT heads, were everywhere.

While some disagree that the price of oil was a bubble, the chart certainly looks like one. The aftermath saw oil stepping into an empty elevator shaft, taking the 150 day rate of change to levels which we haven’t seen in a long, long time:

In fact, I think the pendulum has swung a bit to the other side. Just today there was a report from the International Energy Agency that for the first time in 25 years there will be a decrease in global oil demand.

While I get giddy at the thought of OPEC countries, who are often pariah states, being financially humbled, I think oil prices will stop going down for a while here. OPEC has already been caught with their pants down and are scrambling to cut production as fast as possible. But they are caught between a rock and a hard place since the more they cut, the less revenue they will have.

Interestingly enough, for a few months, oil stocks have been doing better than the underlying commodity. Here’s a chart comparing the CBOE Oil Index and the futures price of crude oil:

When the ratio increases, it denotes that equities are outperforming crude oil itself. My call in mid September was, to be kind, horrible. Both oil prices and oil stocks continued to fall. But oil stocks soon after started to go sideways, refusing to fall along with crude. Here’s an interesting video from the WSJ:

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

My previous position on gold has been wrong. At least so far. I didn’t think it would punch through the resistance at $725 but there it is, firmly established above that level now. So take the following with a truckload of salt:

An almost perfect double top is forming on the chart. We have an uptrend where price has appreciated for a few months and then the two peaks which are about the same height. The support line is just below the current price. If it is violated a picture perfect pattern may unfold.

Something remarkably similar is going on with crude oil:

In the summer I turned bearish on the oil sector as there was a buying panic underway. Oil stocks continued to rise into July but then stumbled badly. Their low was in mid-August, along with all the other sectors out there, as I was pounding the table to go long.

Bullish percent indices are very useful in timing the market. Right now the bullish percent index for the energy sector is at 38% which is low but not too low. And for the gold sector the bullish percent is just below 50%, smack dab in the middle of nowhere.

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.

One of the bright spots of this bull market has been the oil and energy stocks. It is no secret that this sector is one of the highest relative strength sectors out there. A great proxy for this sector is the Energy Select Sector SPDR (XLE).

The chart looks great. A strong long term uptrend and a recent break out to new highs. But things are never that simple. Taking a look at the market internals of the sector shows that it is panting for breath as it reaches these new highs.

Distance from Moving Average
In fact, by a simple measure of the distance from its 200 simple day moving average, the sector has reached a level which has historically marked intermediate tops. The most recent incidences of this were:

March 2005
September 2005
(late) January 2006
April 2006

As you’ll see on the chart below, all were great times to exit this sector and ring the cash register. The other side of this simple indicator was also quite telling. It reached a low in June 2006, September 2006 and January 2007. Each of those times were very low risk opportunities to go long.

Click to Enlarge Graph

But it isn’t just the distance from the long term moving average which warrants caution. I like to see many different metrics confirm the same message. And that’s what we have right now. So lets go through a few of the really good ones.

Oil Sector Breadth
Closely related to the previous indicator, the number of stocks within the sector that are above their long term moving average is also high. Right now more than 92% are above their 200 day moving average. But this can remain very high for a prolonged period of time as the rally continues. All it can definitively say right now is that oil stocks are not oversold. As if we needed to be told that

But the number of stocks above the shorter moving averages are also very high. There are 96% and 92% trading above their 10 day and 50 day moving averages, respectively.

ISEE Oil Stocks Sentiment
The latest ISEE call/put ratio for the Energy Select Sector SPDR (XLE) is through the roof. I haven’t bothered to check but I wouldn’t be surprised to find it to be the highest recorded ISEE ratio ever. This means that relative to puts, a tonne of calls were bought yesterday. Sure, that’s only one day, but nevertheless, not a good omen at all for the bulls.

Oil to Oil Stocks Ratio
A great way to value oil stocks is to compare it to oil itself. The same way that we use the k-ratio for gold stocks. Lets call this the c-ratio (for crude). So we take the Energy Select Sector SPDR (XLE) and we divide by the price of crude oil. What we find is that when the ratio hits 0.70 or lower, that’s a great time to buy oil stocks. The higher the ratio, the less attractive the future performance of oil stocks.

This is a rough guide but it makes sense. Oil stocks are for the most part the same as barrels of oil. The only difference is that oil stocks are comprised of oil under ground, while oil (such as light sweet crude) has been pumped up, refined and packaged. Right now, this ratio is 1.02 - not the highest level it has seen but definitely not the time to buy oil stocks (graph not shown).

Bullish Percent Index
Finally, the bullish percent index is also confirming the ‘toppy’ picture for oil stocks. The bullish percent for the S&P 500 Energy Sector is at 91% right now. Technically, it can go higher to 100% but that is very rare. Historically, such high bullish percent readings have accompanied market tops (see graph below).

Click to Enlarge Graph

Here are the recent instances where the bullish percent had flagged a top:

March 2005
August 2005 (too soon)
(late) January 2006
December 2006