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.

Last summer, on June 2007, to be precise, I wrote that the caution was warranted for energy sector. Let’s take a look to see how I did and what lies ahead for this area of the market.

The energy sector managed to push a little bit higher in July 2007 but it then succumbed to the general market weakness. So since I wrote about my apprehension it didn’t go anywhere really for the next two months:

The strength of this sector was undeniable in 2007. In fact, last year it bucked negative seasonality to deliver one of the best sector returns. Usually, from the beginning of June to the beginning of December energy stumbles. In fact, in the past decade only 3 years have bucked this negative seasonality. On the other hand, once December rolls around, things do tend to rock and roll.

Seasonality
The logic behind the seasonal influence is the seasonal weakness in the commodities themselves. Natural gas and oil are weakest in the summer (May to July) and strongest in winter. So right now we are just about to enter the worst time of the year to be long oil and gas stocks.

On top of that 82% of stocks in the Energy Select SPDR (XLE) are trading above their 100 day moving average. That’s not the maximum but it is high. As well, the bullish percent for the sector is a bit “toppy”, hovering below 80%:

The smart thing to do was buy in January and March 2008 when the bullish percent spiked down to 20% (and less). But you already knew that because you know how to time the market using bullish percent charts, don’t you?

On Wall Street it depends who you listen to. Goldman Sachs is hyper-bullish on oil awaiting $150-200 a barrel oil while Lehman Bros. thinks that prices will fall to $83 a barrel in 2009 and $70 by 2010.

What about Peak Oil?
I don’t buy into “Peak Oil”. We will either discover more oil, better extraction methods for existing reserves or move to alternative energy sources. Take new discoveries for example: Thanks to the Tupi discovery, Brazil will become a major oil player - probably joining OPEC as a result. But that is years in the future, assuming all goes according to plan. Petrobras will have to drill more than 16,000 feet under the seabed, itself under 10,000 feet of water. The reward though is tantalizing: 5-8 billion barrels of oil and natural gas.

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