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August 11, 2006

Oil-Stock Bull Seasonals
by Adam Hamilton

Oil stocks played prominently in the news this past week. With the corrosion problem in BP's transit pipelines at Prudhoe Bay necessitating a shutdown of this largest oilfield in North America, oil stocks received far more attention than usual.

The flagship XOI oil-stock index capitalized on this newfound limelight by clawing to new all-time highs. Three consecutive new closing highs were carved on the first three trading days after the Prudhoe Bay news hit. But it would be a mistake to assume oil stocks were driven to new highs by the oilfield shutdown alone.

In the week before the Prudhoe Bay news hit, the XOI closed at two new all-time highs. And the week before that in late July it had closed at another all-time high. While oil stocks other than BP seem to have benefited marginally from BP's Prudhoe Bay woes, at best these problems only moved the sector 1% higher. The XOI was already forging ahead into new all-time-high territory in the weeks ahead of the BP revelation.

While the XOI has nearly tripled in a powerful bull market since its early 2003 lows, it has one unique attribute that makes it one of the most remarkable bull runs I have ever seen. Oil stocks, as their prices have powered higher, are actually getting cheaper in fundamental terms! Oil stocks' earnings are growing faster than their stock prices creating incredible bargain valuations.

Near the XOI's all-time highs in the middle of the week, the elite oil-stock components of this index actually had an average P/E ratio of just 9.5x earnings! To see oil stocks, at all-time highs, trading at cheap valuations comparable to the beginning of great bull markets in stocks is just extraordinary. They are priced as if oil was trading in the $40s, not the $66ish average levels of the past year.

As such, I remain very excited about the bull market in oil stocks. It is rare and wonderful to be able to buy dirt-cheap stocks in valuation terms over three years into a powerful bull run. Usually a sector would be starting to get overvalued at this stage in its bull, but since Wall Street and mainstream investors still don't believe $60+ oil is here to stay they have unwittingly created an incredible opportunity for prudent contrarians.

As an oil-stock investor and speculator, I am certainly interested in understanding the rhythms of this bull. If I can better recognize when the probabilities most favor going long then we can add new trades, both investments and speculations, at these periodic low points. And if I can gain discernment on highly-probable interim highs then we can sell our speculations there for the greatest profits. Timing is crucial in this game.

To further my advancement as a student of this oil-stock bull, I'd like to apply seasonal analysis to the XOI bull to date. Typically used only in futures trading, seasonals attempt to quantify particular times of the year when a price tends to be strong or weak. While the averaging inherent in seasonals makes them inappropriate for use as primary trading tools, they can help illuminate markets from another perspective to fine-tune entry and exit points on trades.

Last week I did some research work on seasonals for the bull market in crude oil. I am using the same approach to build XOI seasonal charts this week, so if you'd like the background on this line of research please read "Oil Bull Seasonals". Before we get into XOI seasonals though, there is an important issue that needs to be addressed.

Despite widespread perceptions to the contrary today, the crude oil price is the primary driver of the oil stocks. This makes sense conceptually and logically. Oil stocks earn their profits from pumping oil. The higher the oil price goes, the larger their profits get. And since stock prices ultimately follow profits, rising oil prices via the mechanism of yielding higher profits eventually lead to higher oil-stock prices.

Today a lot of investors and speculators believe the XOI is at the mercy of the general stock markets. If the S&P 500 rises, then oil stocks will rise. If it falls, oil stocks will follow. Indeed, watching the XOI and S&P 500 on a daily basis can certainly lead to this perception. I was concerned about this myself last year so I investigated it in an essay. I found that crude oil is far more important than the general markets in explaining XOI price behavior.

Here is a key chart updated from that original essay, "Trading the Oil-Stock Bull". It shows the incredibly tight relationship between crude oil and the oil stocks. If you want to game the big swings in the oil stocks, then you have to watch the big swings in oil. To an uncanny degree, the XOI's fortunes tend to mirror those of oil.

Before we get into the math of this amazingly strong relationship, just take a minute to drink it in visually. The red oil line and the blue XOI line are intimately intertwined for the vast majority of the XOI's bull to date. This is especially evident since the beginning of 2005, when this oil-stock bull really started getting interesting.

Prior to 2005, the XOI was climbing higher along with oil for the most part. But occasionally, like in late 2004, there was a temporary decoupling. Oil was buoyed dramatically in a couple of major speculative spikes in the second half of that year, but the XOI didn't follow. I remember late 2004 well and at the time most oil-stock traders, including me, didn't believe that $50+ oil was sustainable over the short term after such a major spike. So we waited out oil's expected correction and little capital flowed into oil stocks.

But after 2004, the relationship between oil and the XOI tightened up considerably. Note that there have been five major uplegs and/or surges in the XOI since the dawn of last year. Each one of these major XOI rallies was driven, directly, by an underlying rally in crude oil. Since the beginning of 2005, the XOI has only rallied strongly when oil prices were also rallying strongly. And each of these strong XOI moves higher reached its interim apex at or near the time crude oil's own parallel bull move was topping on an interim basis.

Oil is the primary driver of the oil stocks. And mathematically this relationship is even stronger than it is visually in this chart. Since this XOI bull began in early 2003, the XOI has had a staggering 0.976 positive correlation with crude oil. This yields an r-square value above 95%! Thus 95% of the daily price action in the XOI is directly attributable to and/or explainable by the daily price action in oil prices.

While oil stocks do seem to follow the general stock markets from time to time, these episodes are fleeting. Both the XOI and S&P 500 have been in independent bull markets in recent years so they appear to move in sync from time to time. But upon closer examination, there are all kinds of problems with the thesis that the general stock markets are driving the oil stocks. 2004 is the prime example.

Back in early 2004, the S&P 500 entered that year near 1100. Over the next six months it made several valiant attempts to break above 1150 but all failed. It then ground a gradual series of lower lows, a readily evident downtrend, culminating in one just above 1060 this time of the year. So for the first nine months or so of 2004, the S&P 500 and general stock markets faded lower.

If persistent general-stock weakness was to bleed into oil stocks, that was when it should have happened. But the XOI just ignored the stock-market malaise and rallied higher following oil's ascent. During the first nine months of 2004 when the S&P 500 was unchanged at +0.2%, the XOI powered 24.2% higher! You can see this visually for yourself in the third chart here.

So even during the better part of an entire year when the S&P 500 was weak, the oil stocks followed oil and ignored the stock-market slump. As I watch the XOI move with the general stock markets every day, sometimes I sure feel like they are highly correlated. But when I step back and study the histories of their parallel multi-year bulls, it becomes crystal clear that oil is the primary driver of oil stocks, not the S&P 500.

Since I researched this last year I have been well aware of this fact, which is the reason I started my foray into seasonals with crude oil itself last week. If we could discern when oil was likely to be strong seasonally, which it is incidentally for the next six weeks or so, then we could gain a better idea of the probabilities governing the sell timing for our current open oil stock, gas stock, and oil-and-gas-stock options trades outstanding in our newsletters.

But I was also curious about the actual seasonals of the XOI itself. While I suspected they would follow oil's seasonals pretty closely due to the XOI's strong correlation with oil, I was wondering if they would reveal subtle differences that would help our trading timing. Indeed they did! These charts, once again, are built with the same approach I discussed last week. They encompass 2003 to 2006, the years of the current XOI bull.

The XOI's bull to date has been quite impressive so far in seasonal terms. On average the index has risen 30% or so a year, from 100 indexed to around 130 indexed. These gains are remarkably consistent throughout the year too. Other than a minor correction in October, the seasonal odds so far in the XOI's young bull favor it rising year round. Nevertheless, there are some good-probability trading times lurking in this general bullishness.

Going into each year, the XOI has exhibited modest strength on average in January. But in February a nice rally ensues, driving the XOI up to the top of a trend channel that is seasonally likely to last into early June. The XOI then spends the spring slowly meandering higher, not really doing anything exciting in either direction. But in May the XOI tends to correct to its seasonal support for the first time since early February.

As such, mid-May is a high-probability-for-success time to add new long positions in oil stocks and options. We did this ourselves in Zeal Speculator this year, layering in a half-dozen new oil-stock call trades between mid-May and mid-June. Last week these trades had nice unrealized gains averaging 62%. We launched these trades in May and June not due to these seasonals, which I wasn't yet aware of, but because the XOI was near its 200dma, the best time to be long in a secular bull.

Then starting in June, the XOI's seasonal uptrend increases. While most sectors of the stock markets don't tend to fare very well over the slow summer vacation season, oil stocks are a welcome exception. For a variety of reasons including high summer gasoline demand and hurricane season jitters, oil prices and therefore oil stocks tend to do well in the summer months. They are a great summer speculation.

Incidentally, for you fellow investors and speculators already long oil stocks, they tend to have their sharpest and biggest seasonal surge of the year at the end of August. So if the XOI stays true to its seasonal form this year, we could be in for some big gains in our various oil stock positions in the coming weeks. I am excited to watch how this year plays out relative to these seasonal averages. And this surge doesn't even end the summer rally, which keeps rising into the latter days of September!

This summer rally climaxes in seasonal terms at the end of September, incidentally right near where oil's seasonal climax occurs. If you are a short-term speculator just along for the summer ride, late September is therefore likely to be the best time seasonally to realize your profits. As I mentioned last week while discussing oil seasonals, this is when we hope to realize our large oil-stock call options gains at Zeal as long as our primary trading indicators concur with the seasonals at that time.

Then the only real seasonal XOI correction tends to occur in October. This corresponds to a seasonally weak time in crude oil, after summer demand for gasoline fades and the hurricane season winds down. Interestingly though, the XOI seasonal correction doesn't last long. Traders have a great chance to buy in mid-October and one more in early November, and then this whole cycle begins anew. Intriguingly oil doesn't bottom seasonally until early December, so XOI traders are anticipating the oil bottom and buying in early.

One fascinating attribute of the XOI that makes it especially conducive to options speculating is its remarkable consistency. It is not particularly volatile, its uplegs and corrections are mild and it keeps climbing on balance, which makes it a fairly low-risk platform from which to launch individual-stock options trades. While I was already aware of this, I was still surprised by the very low standard deviation bands on the inset chart above.

Last week the crude oil seasonals showed enormous standard-deviation bands. In other words the oil data from each of its underlying bull years was so widely scattered that its average in the form of seasonals had to be taken with a grain of salt. The bigger the standard deviation bands in analysis like this, the more the final indexed chart is a product of the smoothing inherent in averaging rather than actual tradable tendencies.

But since the XOI is generally so mild in volatility terms, its standard-deviation bands above are far tighter than oil's. Over the entire year crude oil averaged a standard deviation of 26.2 indexed, and this SD ballooned dramatically as the year marched on farther away from the initial January 1st index anchor. Meanwhile the average XOI standard deviation over the entire year was just 12.8 indexed, less than half of oil's. This has important implications for traders.

In the inset chart above, the tighter the yellow standard-deviation bands the higher the probability that the XOI will continue to behave the same way seasonally as this bull marches higher. Note at the May lows, for example, how tight the SD bands become. This tightness of the annual XOI data that was indexed to make these seasonals shows that this May-low tendency really exists, it is not just a product of averaging smoothing.

With XOI SD bands tight in general compared to oil, we know that the XOI seasonal behavior is very real and tradable. While I would still not use XOI seasonals as a primary trading tool, I think they are valuable as a secondary tool to fine-tune entry and exit timing. For example, if the XOI is starting to look overbought in conventional technical terms in early September, I would consider holding a couple more weeks anyway to try to exit near the seasonal top of late September.

All my caveats of using the oil bull seasonals I discussed last week are moderated considerably in the XOI's case due to the relative tightness of its underlying data. This tradable consistency is also apparent in the true monthly version of seasonals, where each calendar month is individually indexed. For example, every January of this bull is indexed and averaged, and the resulting XOI tendency in calendar January alone is plotted below.

Please be careful with this chart. Each month starts at 100 and is a totally discrete unit. The sharp lines that connect the end of one month with the beginning of the next are unwanted graphical artifacts from our charting software trying to connect the dots. So please ignore these sharp moves back towards 100 on the last day of any month. Each month in this final chart must be considered in total isolation from its neighbors.

In monthly indexed terms, the XOI's stellar consistency also shines through. There are not any outlying strong months that really stick out. If we define a 3% monthly gain as strong, then there are no fewer than six months out of each calendar year with the tendency to achieve 103 indexed at some point. Thus in pure monthly terms there is really no clear best month and hence no clear sell signal for speculators to realize long profits.

Weak months are rarer, there are only three months that see 98 indexed at some point. May is slightly below this and also shows up as a great buy point here. October is the only truly weak month, likely to head down to 95 indexed, or fall 5%, in the first couple weeks of that ugly month. In terms of monthly seasonals, there is no better time to add new oil stocks or oil-stock call options than during the middle of October.

The most striking feature about this monthly-indexed XOI chart for me is how tight the range of monthly gains and losses happens to be. There is little month-to-month variance and the XOI has a far greater probability of rising most of the time than it does of falling. This XOI bull continues to be one of the most stable and reliable in the world, probably driven relentlessly by the incredibly cheap oil-stock valuations.

Just as with the oil seasonals last week, I would not use the XOI seasonals as a primary trading tool. Much better and more reliable tools exist, such as the Relative XOI. Nevertheless, the XOI seasonals should help traders fine-tune their trades by helping to flesh out probabilities on excellent seasonal entry and exit points.

If primary indicators are suggesting strong XOI buys and XOI seasonals are weak, this increases the odds that new long trades added then will prove to be very successful. Conversely if primary indicators are suggesting that the XOI is overbought and the XOI seasonals also happen to be near usual topping levels, it will probably end up being a good time to realize profits on long speculative positions. The more a trader can understand the probabilities governing this oil-stock bull, the more success he is likely to have in trading it.

At Zeal we hope to exploit these seasonals on both sides this year. I'll certainly be looking to realize our growing profits in oil stocks and oil-stock calls in our newsletters by late September. And then if the expected October correction in this sector materializes, we will be ready to start redeploying in a fresh new oil-stock campaign to ride the highly likely continuation of this strong oil-stock bull into 2007. It'll be a phenomenal time to buy if our primary long indicators and seasonal lows match up. I am really looking forward to it.

Near these probable seasonal lows this fall, we will be looking to add and recommend new oil stock and oil-stock call options trades that are highly likely to thrive in the next mighty oil-stock upleg. Please subscribe to our acclaimed monthly newsletter today so you don't miss these exciting coming opportunities!

The bottom line is despite the new all-time highs in the XOI this week, oil stocks remain radically undervalued today. Wall Street still holds out hope that oil is heading back down to the $40s and has priced the oil stocks accordingly. But this is highly unlikely as global oil demand growth continues to outpace supply growth. Sooner or later mainstreamers will realize this and flood into cheap oil stocks.

XOI seasonals can help fine-tune the timing of entry and exit points for oil-stock investors and speculators to maximize gains in this ongoing oil-stock bull. Since the XOI is so stable and its individual years' data underlying its seasonal averages is so tight, probabilities are high that these tradable seasonal tendencies will persist. We may as well exploit them.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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