Trader’s Narrative

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.

“Hello, I’d like to order a rally please. Yes, the financials. Good. Can you get that here in less than 45 minutes? ok. And you take plastic right? Ahh, okay. Thanks Bye.”

The financial sector - I use the Financials Select Sector SPDR (XLF) as a proxy - has been a horrible spot in the market lately. Ever since it fell out of bed in late February this year, it has shown one of the weakest relative strengths of any sector. While the market powered ahead in April and May to reach new highs, the best the financials could do was reach their previous highs again and fall down once more.

It has been ugly. But are we anywhere close to putting this sorry mess behind us?

Looking at the bullish percent chart for the sector, I noticed that it has a relatively low 63%. That may not seem low but keep in mind that since the bull market, this sector has tended to bottom around 55%-60%. The market correction in March 2007 only took the BP% down to 65%. Maybe that’s why it didn’t rally as much.

In any case, although the bullish percent is relatively low, it still isn’t low enough to merit a rally here. Take a look at the graph and you’ll see what I mean:

Click to Enlarge Graph

The internals of the sector don’t look that appetizing either. Taking a look at the number of stocks within the sector trading above their moving averages shows: around 50% above their 200 day MA, 20% above their 50 day MA and only 10% above 10 day MA.

When we’ve seen such a short term oversold situation in the sector, it has resulted in atleast a bounce. But not until we see less stocks above their long term MA are we going to set up for a meaningful rally. Today we bounced 1.5% but I don’t think we’re in the clear yet.

The bright spot is that short interest in the S&P Financials Select Sector SPDR (XLF) is at a multi-year high. The last time it was at this level was April 2005. From a sentiment point of view this is positive and it also means that all those short sellers are providing quite a bid under the price.

To conclude, I don’t think we’re seeing any sort of capitulation here. The worst is if we just drip lower. And I’m afraid the technical picture looks like we might just do that some more. If that is the case, it doesn’t bode well for the market in general either.

Here are the top 10 components (by capitalization):

Citigroup Inc. (C)
Bank of America Corp. (BAC)
American International Group Inc. (AIG)
JPMorgan Chase & Co. (JPM)
Wells Fargo & Co. (WFC)
Wachovia Corp. (WB)
MORGAN STANLEY (MS)
Goldman Sachs Group Inc. (GS)
Merrill Lynch & Co. Inc. (MER)
American Express Co. (AXP)

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