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July 20, 2007

Energy Stock Correction
by Adam Hamilton

In a rapidly developing world starved for energy, the powerful surge in energy stocks in recent months certainly has a strong fundamental foundation. With decades left to go in the massive industrialization of Asia, global energy demand is going to continue relentlessly growing for many years to come.

And as long as worldwide demand growth exceeds supply growth, energy prices have no economic choice but to continue to rise on balance. This is why energy stocks are probably the best long-term investment in the world today. I started speculating in them in 2001 and have laid up big investments in elite energy producers in the years since. In the specific case of oil stocks, their valuations remain so low that they are also true value plays in addition to being highly leveraged to the structural energy deficits.

Despite believing energy stocks are a dream investment today and having a large portion of my long-term investment capital deployed in them, as a student of the markets I am well aware that no bull rises in a straight line. Secular bulls flow and ebb, climbing two steps forward in exciting uplegs before retreating one step back in necessary corrections. Energy stocks are certainly no exception to this ironclad rule of the markets.

Today I suspect we are near one of these characteristic bull-market times when an ebbing is due. Energy stocks have soared since early March, right after the late-February China-stock-selloff scare buffeted the stock markets. But as usual, so much strength has led to clearly overbought conditions. In years past in this bull when energy stocks reached similar technical extremes, corrections soon emerged to bleed off the temporary excesses of greed that spawn near interim highs.

Bull-market corrections are a double-edged sword for investors. On one hand, it is no fun seeing your existing positions get hammered for a spell before the next upleg carries them to new highs. But on the other hand, corrections provide the best opportunities within a bull to deploy more capital into a high-performing sector. Since corrections yield optimal times to buy, investors should view them as opportunities, not threats.

Gaming corrections in energy stocks is extra challenging because this sector is not homogenous. Some companies produce oil, others natural gas, still others uranium, others coal, and some a combination of these major energy sources. But while oil, natural gas, uranium, and coal always have subtrends in play that affect their producers, there are still some overarching strategic connections among these companies.

In terms of market capitalization and prominence in the world stock markets, oil stocks utterly dwarf all the producers of the other energies combined. As such, oil stocks are often looked to for energy leadership. If oil stocks are rising, the other energy producers tend to rise in sympathy. And if oil stocks are slumping, the other energy producers tend not to fare too well either. So oil stocks typically set the tone for all energy stocks.

And oil stocks are rapidly becoming mainstream investments. Four or five years ago it took a true contrarian to buy oil stocks. The oil prices were low and arguments abounded about how oil was abundant and would get even cheaper. But thanks to the magnificent run in oil since its sub-$18 low in early 2002, mainstreamers are now big believers in oil stocks. Pretty much universally today professional money managers believe that energy stocks are an essential component of every portfolio.

This is great news as it is attracting mainstream capital into oil stocks and driving up their prices, but mainstream involvement has a drawback too. When the general stock markets correct, mainstreamers sell everything. When our current overdue stock correction inevitably arrives, oil stocks will certainly be sold off in the melee. Even if money managers like them, they are forced to sell all their sectors evenly during corrections in order to keep their portfolios balanced.

The correlation r-squares between the XOI oil-stock index and crude oil, and between the XOI and the stock markets, have been very revealing lately. Between December and the end of February, 73% of the XOI's daily price movements were explainable by crude oil's while the XOI's r-square with the S&P 500 was -2%, or totally uncorrelated. But from March to May, the XOI's r-square with oil fell to 45% while it rocketed to 93% with the S&P 500! In other words, during the initial three months of the recent stock rally 93% of the oil stocks' gains were directly statistically explainable by the S&P 500's gains!

So oil stocks' performance heavily influences other energy producers and the oil stocks themselves are often driven by general-stock-market sentiment. Thus if you believe a correction is approaching in general stocks, then realize that oil stocks and hence other energy stocks will most likely get dragged down in sympathy. Such energy-stock corrections happen from time to time and are nothing to fear, but anticipating them creates outstanding trading opportunities.

With oil stocks dominating the energy-stock arena, we can look to the XOI oil-stock index as a sentiment indicator for energy stocks as a whole. Uranium stocks generally have a fairly high correlation with the XOI, and the XNG natural-gas stock index virtually moves in lockstep with the XOI. Oil stocks truly are the 800lb gorillas of the entire energy-stock spectrum and they wield vast influence across all energy stocks.

And as these charts reveal, the oil-stock sector as measured by the XOI is definitely overbought today. The XOI and its key technicals are charted on the right axis. The red relative XOI line is charted on the left axis. The rXOI, or XOI divided by its 200-day moving average, offers excellent insights into when the index is overbought or oversold (the time to buy). I'll discuss the rXOI in more depth shortly here.

Oil stocks, and by extension energy stocks in general, have advanced in the typical stair-step bull-market fashion. They are grinding higher on balance, reflecting incredibly bullish global energy fundamentals. But note above that the XOI only surged higher some of the time. Big uplegs are the exception, not the norm, and they are followed by necessary and healthy corrections. Most of the time the XOI just modestly consolidated higher with little fanfare and excitement.

In fact, since the XOI's early 2003 lows, there have only been three major uplegs. All are numbered above. These are surge uplegs, or fast moves higher that generate a lot of excitement in oil stocks and draw in new buyers. When CNBC starts talking a lot about oil stocks after an impressive run higher, odds are it is near the top of a surge upleg. The latest powerful run in the XOI since early March definitely fits the surge-upleg profile.

As these periodic surge uplegs mature, sentiment becomes way too unbalanced to the greed side. Corrections are therefore necessary after these big runs to rebalance sentiment and bleed off the excessive optimism. Following these corrections, the XOI starts another grinding consolidation higher with a modestly climbing uptrend. This gradually gets investors and speculators comfortable with the new higher XOI levels and lays the foundation for the next surge upleg.

The key point to realize here is the bull markets in energy stocks, though very profitable, have certainly not been linear. Most of the time they just kind of drift sideways to higher. Sometimes they surge up very rapidly, but the price to pay for such sharp gains is a partially-offsetting correction. Since we have just witnessed such a strong surge upleg, odds are we are facing another correction very soon here.

The red rXOI line above showcases one of my favorite ways to measure how overbought or oversold a particular market is at any given time. By dividing a price by its 200-day moving average and plotting the result, a kind of horizontal trading range is created. In this case it shows the XOI as a constant multiple of its 200dma. When this number gets too high the XOI is overbought and when it gets too low the XOI is oversold.

If you are not familiar with it, this is all based on my Relativity trading theory. All bull markets flow and ebb, run higher in uplegs and then retreat a bit in corrections. These major moves can be empirically measured based on the distance between a price and its 200dma. In uplegs prices diverge and stretch above their 200dmas and in corrections they converge again. The really interesting thing is that within a given bull, the relative extremes at which these turning points happen tend to cluster at certain levels. So when a relative number hits these levels again, probabilities for a contrary move become quite high and tradable.

As the chart above shows, in the early years the rXOI tended to have a range between 1.05x on the low side and 1.20x on the high side. We traded oil stocks with success during those years based on this range. But lately the XOI has been bottoming lower, down under 1.00x relative. As such, I am dropping the lower end of the rXOI's trading range to under 1.00x to better reflect recent market conditions.

With the rXOI usually tending to run between 1.00x to 1.20x, this establishes a trading range with very definite probabilities. When the rXOI falls under 1.00x, in other words the XOI falls under its 200dma, odds are it will prove to be a great opportunity to add long positions in oil and energy stocks. This last happened in March and the XOI has soared since then. Under 1.00x on the rXOI scale is the oversold zone.

But when the rXOI gets over 1.20x, or the XOI stretches more than 20% above its 200dma, it is in the overbought zone. At this point greed is rampant and probabilities favor an imminent correction. In this entire bull to date as you can see in these charts, the rXOI has never been able to spend much time above 1.20x. Provocatively over the last couple weeks, once again the rXOI has forged into this high danger zone. If the XOI proves true to its bull precedent, it won't linger at such extremes for long.

This latest surge upleg since early March has a lot in common with its predecessors technically. This time around our latest rXOI high was 1.239x above the XOI's 200dma. Back in 2005 the rXOI topped at 1.288x and 1.268x respectively in the two surge uplegs that year. But these higher historical numbers are a bit misleading since the rallies that led to them also started at a higher 1.05x base. Our latest surge above 1.20x launched from 0.974x which gives today's upleg the greatest relative range in this bull so far.

Since early March, the XOI has soared 37% higher in 91 trading days. This is remarkably similar to the last surge upleg of mid-2005 that ran 39% higher over 95 trading days. By that time the second surge upleg was so overbought that it had no choice but to correct hard. The XOI promptly fell to bleed off excessively greedy sentiment. Given that earlier upleg's similarities with the XOI today, I suspect a similar correction episode is highly probable soon.

All an XOI correction would need to do to reestablish sentiment balance is fall back down to the index's 200dma. Today this is running around 1225 as you can see in this chart. The XOI will probably end up falling slightly below its 200dma though as corrections tend to overshoot to the downside just like uplegs overshoot to the upside. Once fear or greed are entrenched, their momentum often keeps prices going farther in the same direction than traders expect.

Once the XOI falls below its 200dma, it will again be in the oversold zone and oil stocks will be strong buys. Investors and speculators who heed these high probabilities of an imminent correction could really grow their oil stock holdings. Why invest new capital in oil stocks today near 1500 on the XOI when odds suggest the XOI will be trading in the 1200s within the next few months? At the XOI's 200dma, a given amount of capital will buy about 20% more shares in oil stocks than it would today.

While there is little doubt that oil stocks are overbought today as these technicals reveal, traders often like to ponder catalysts for a correction. While catalysts aren't really necessary in pure technically overbought conditions, there are still a couple to consider today that could really affect oil-stock psychology adversely and trigger widespread selling.

With oil stocks now mainstream investments for the most part, any general-stock correction would rapidly bleed into oil stocks. Not only have the general US stock markets risen for years now without any meaningful correction, a major unsustainable anomaly, but the Chinese stock markets remain right on the cusp of a speculative mania failing. General stock selling in the US, whether it is spawned by sharp plunges in China like in late February or any other factor, is likely to hit the oil stocks hard.

Another possible catalyst is the hurricane season. A lot of speculators have piled into oil stocks in anticipation of hurricanes. So far though, thankfully this hurricane season has been a total bust like last year. Last year when no major hurricanes swirled into the Gulf of Mexico by early August, oil stocks started selling off sharply as psychology turned negative. This could happen again unless some major storms roll in soon.

And even if a hurricane does hit the Gulf, oil companies spent countless billions after Katrina to harden their offshore infrastructure so widespread oil/gas disruptions of a similar magnitude are really unlikely again. So speculators buying oil and gas stocks solely for hurricane reasons will probably be disappointed even if a major storm does move into the Gulf. When their hopes of hurricane disruptions start to fade, they will start selling their oil and gas stocks.

Thus there are a lot of reasons why the oil stocks, and the gas stocks that tend to follow the oil stocks in lockstep, are due for a healthy correction. If you are an investor, I wouldn't worry at all about this correction. The next upleg will more than make up for it. If you are a speculator, you may wish to raise your trailing stops so more of your gains are preserved when the correction arrives. By running trailing stops instead of selling outright here, your capital can remain deployed in case the XOI goes still higher first before it corrects.

And for both investors and speculators, start building cash for the next 200dma approach of the oil and gas stocks. The highest-probability-for-success time to add new long positions in any bull market is when prices temporarily return to their 200dma as a correction matures. By buying in these periodic dips instead of near tops, you can build a much larger portfolio over the course of the bull. Prudent traders always seek oversold conditions to buy and steadfastly ignore the temptation to buy when everyone else wants to near tops. Such an excellent oversold buying opportunity in oil and natural-gas stocks is likely approaching.

Since most uranium stock owners also own oil stocks, the oil stocks' fortunes also weigh heavily on uranium-stock psychology. So if oil stocks indeed correct soon as they ought to, the selling will probably bleed into uranium stocks as well. But uranium stocks are nowhere near as correlated with oil stocks as the natural-gas stocks are. Because of this, uranium stocks are a unique case in the energy-stock world.

Uranium stocks powered sharply higher earlier this year to staggering greed-driven heights. But in the last two or three months, most have already started correcting. Many are already down to their 200dmas today. Although they will probably trend lower with oil stocks, the more beaten-down ones are not as likely to be affected since a lot of their selling is probably already out of the way. So fantastic buying opportunities should manifest in uranium stocks before the oil and gas stocks bottom.

With uranium soaring, hundreds of new companies have entered the fray trying to ride the bull. During the last several months, my business partner Scott Wright and I have researched hundreds of them. After countless hours of investigating, we narrowed down the vast field of uranium stocks to our favorite 20. Just this week we published a brand-new in-depth fundamental report on Zeal's 20 Favorite Uranium Stocks that details our research. Unfortunately there are a lot of worthless companies in this crowded sector, but we painstakingly sifted through all the chaff to find the best.

If you are interested in adding elite uranium-stock positions in the upcoming buying opportunity, buy our new report today! It will save you hundreds of hours of research and give you the fundamental scoop on some of the most promising uranium miners and explorers on the planet. The companies we profiled in this report are extremely impressive and well-positioned to soar with this uranium bull.

We also publish an acclaimed monthly newsletter where we research the commodities markets with the mission of launching high-probability-for-success trades in elite commodities stocks at technically-opportune times. Join us today to see what we are trading, when, and why. As this probable energy-stock correction matures, we are looking forward to adding a bunch of new high-potential energy stock trades.

The bottom line is all bulls flow and ebb, and the energy-stock bulls are no exception. Since March, many energy stocks have been bid up along with the general stock markets to technically overbought levels. In the past when the oil stocks, the dominant sub-sector in energy, have reached such extremes, a correction back down to their 200dmas was imminent. Another such correction is highly probable today.

Corrections are healthy and necessary to rebalance sentiment within secular bull markets. As such, they should be seen as opportunities, not threats. Prudent investors and speculators who build up cash positions now should be able to buy on the order of 20% more shares in their favorite energy companies after a correction than now near the tops. Anticipating probable corrections can be very profitable.

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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