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.

The Dow Jones Transportation sector is acting really wonky. At first glance, it might seem to be getting tarred with the same brush as the general market. The wonky part is that it has completely decoupled from the crude oil market.

For example, on October 29th, 2008, West Texas crude oil futures went into free fall, closing the day almost down 10%. On the same day, the Dow Jones Transports went down 5.2%. Huh?

Other than the plausible explanation that people are selling everything, is that the market is starting to discount an economic slowdown which will damage the transport sector more than a decrease in fuel costs.

But in any case, the transport sector has goetten clobbered out of proportion. Take a look at the bullish percent index for the sector to see what I mean:

The index closed last week at 5% - meaning that only 5% of the components of the Dow Jones Transportation index are trading with a point and figure buy signal. Five percent.

To find a time when the number was this low we’d have to go back to the beginning of the year and then the summer of 2002. The advantage is that such an extreme oversold is occurring right at support (~4100 on the Transports index) where it has found support two other times - summer of 2006 and early 2008.

I don’t know if the market is signaling an economic shift with the way this sector is melting down, but I am willing to wager that it won’t be straight down. We’re about to see a bounce or snap back rally.

While the transportation sector has been going strong, the airline industry - a sub-sector of transports - is scraping the bottom of the graph at multi-year lows.

Imagine how well the transportation index would be doing if the airlines had been contributing or at least keeping up with the rest of their peers. Accounting for almost 11% of (dead) weight, the following airlines are in the Dow Jones Transportation Index:

• AMR Corp. (AMR)
• Continental Airlines Inc. (CAL)
• JetBlue Airways (JBLU)
• SouthWest Airlines (LUV)

Recently there’s been some turmoil in this sector with a few bankruptcies, fleets being grounded and just today, Northwest Airlines and Delta decided to merge. This sort of shake up is common place in this sector and it happens ever few years. Airlines are a notorious black hole for capital - even the sage of Omaha, Warren Buffet lost his shirt when he strayed too close.

But do the extremely “cheap” airline stocks mean that this sector is a buy? or put another way, are they cheap enough?

From a fundamental point of view, I can’t say that I have a clue. But from a technical perspective, I don’t think so. Here’s why:

The really important double bottom that was formed in the end of the last bear market was at 30. In January 2008, the AMEX Airline Index (XAL) ricocheted higher after grazing the same level. But in contrast to before, the ensuing rally was short lived and it subsequently fell below that important support line.

So right now the index is approaching the 30 level again but now it is facing it from below, as resistance, rather than support. That’s an important distinction.

Also, it is no longer in step with the parent sector (transports). The bullish percent index for the Dow Jones Transportation Index is at 55% while it was at 15% and lower in 2003. I am too lazy to look up the Airlines bullish percent index but my hunch is that it would be wallowing in the 10-20% range.

So I wonder… why does the market shrug off all the reasons why the land and sea transportation companies’ stocks should be sold (high energy costs, recession, etc.) but not the airlines?

Finally, taking a look at the component stocks tells me that they are either below or far away from a base or support level. Take for example, JetBlue (JBLU): In March 2003, when the airline sector put in its major multi-year bottom, JBLU traded at $10/share. It is now trading at $5.18/share. Almost half that level.

The opposite could be said of AMR because it traded at $2.50/share in 2003; which means that it still has a lot of potential room to fall from its present level of $9.34/share.

The last time I visited the transport sector, it was in mid August when the whole market was making its intermediate low. Like many sectors, the transportation sector had an extremely low bullish percent index. It reached a low of 15% which was as low as it had been for more than 2 years:

And once again, the bullish percent chart for this sector is in deep oversold territory. It is already bouncing back but there is still an opportunity to pick up great bargains in rails, trucking and shipping stocks.

Although the sector was deeply oversold the index didn’t really respond last time (August 2007). I think this time price will be more accommodating to a rally since it has fallen to major support and also, we’ve already seen bargain buying create a spike bottom.