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.

Who could have imagined that with crude oil at +$110, the transports would be one of the highest relative strength sectors out there?

Well, if the stock market was strictly logical we would have figured it all out centuries ago. This is exactly what makes trading so fascinating.

Bullish Percent
The recent swing low was in early January, when the bullish percent for the sector reached a measly 5%. Five percent!

Do you know the last time they were that low? Try July 2002.

But since you’ve read my post about timing the market with bullish percent charts, you know all about that and of course, took obscene advantage of it. Of course.

But there’s more going on here. Take a look at this chart:

The top chart shows the relative strength of the transports (to the S&P 500). Notice the higher lows and the higher highs. Then check out the completed head and shoulder formation with a nice quick retest of the neckline.

Believe it or not, it has already made it to the October 2007 highs. In contrast the Dow Jones Industrial average is still well below that area on its chart.

Dow Theory
According to Dow Theory, major signals are given when the two major sectors (sometimes along with the third: utilities) confirm each other.

While the recent action is not bullish per se, at least according to strict Dow Theory, it sets up what is called a “non-confirmation” - in this case, for a decline. That is, because the Dow Transports didn’t confirm the lows that the Dow Jones Industrial Average reached but instead headed up.

What would be truly bearish, according to Dow Theory, is if both the Dow Jones and the Transports print prices lower than their January levels.

So right now what we have is simply the potential for a buy signal, if the Dow Jones continues to rally and rises above its February highs.

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.

Other than the financial sector, which is extremely oversold, the only other major sector in the market approaching such levels right now is the transports.

After participating in the Dow Theory buy signal in late April, the transports powered to an all time high last month (5487). But even as this sector was climbing into thin air territory, its bullish percent index was falling.

This sort of divergence is usually a bad omen as it means that less and less stocks in the sector are participating and fewer and fewer are responsible for pushing the index higher.

Anyway, historically, when the bullish percent index for this sector reaches 30% it is a good time to hunt for longs and eschew the short side.

You can see details of how this signal worked out last summer.

Transportation stocks are cracking right, left and center. GWR is a freight railroad operator that gapped down large today:

The first print and candle were without the specialist so they had scant volume. But by the second and third candlesticks, GWR was open for trading and it had printed extremely unusual volume (purple square). After the first 15 minutes of trading, it was obvious that GWR was not only a gap down, but it was in play. This is why I drilled down and looked at it through the shorter time interval of 5 minutes.

The second and third candles left long lower wicks which meant that buyers were coming in and supporting price. On the daily, GWR had put in a nice double top and had now clearly cracked after spending some time dawdling below the long term moving average. But still, here was a hint that bargain hunters were stepping up.

The next candle was wide range and it closed up! What’s more it was a very strong candle with the close being almost at its high. As well, this took price above the opening range’s high. The next few candles were narrower in range as price contracted. They weren’t terribly strong candles but they had higher lows (look carefully).

The entry was at the break of the 7th candle’s high (green line) with the stop loss being below (red line). GWR trended up in a semi-orderly fashion and went through a few more contraction and expansionary phases - can you spot them on the chart?

I featured this chart today to show that eventhough a stock gaps down with a terrible technical picture on the higher time frame, it can actually go up! Everything is possible when it comes to financial markets and often times it is what you least expect or simply ignore that will come to pass.