Oil Stocks Deeply Oversold 2

By: Adam Hamilton | Fri, Oct 14, 2011
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The recent recession-fear craze hammered commodities prices, crushing the stocks of the companies that produce them. Commodities stocks were wholesale abandoned by frightened traders, left bludgeoned and bleeding. But driven to deeply-oversold levels, they got incredibly cheap relative to their underlying fundamentals and bull-market precedent. Oil stocks are a shining example of this great opportunity.

Crude oil is the king of commodities, and the companies that produce this essential resource enjoy a unique position. As the world's only meaningful transportation fuel, oil is the foundation of this entire planet's vast and complex logistics network. Oil truly is the lifeblood of our global economy, as without it nothing moves. And if goods can't be shipped, stores have nothing to sell and we all starve to death.

Once oil is consumed, it is gone forever. So huge quantities must be produced every single day to ensure the world doesn't grind to a halt. And oil demand is remarkably inelastic, the world continues to voraciously consume enormous amounts whether traders as a herd are euphoric or terrified. But though oil's strongly-bullish underlying supply-and-demand fundamentals persist, traders' unchecked emotions often wildly batter the oil price about.

Oil's fundamentals have driven a powerful secular bull that started way back in late 2001 (at around $17 per barrel). Because global demand growth has continued to exceed global supply growth, oil prices have climbed on balance. Think of the fundamental impact in oil-price terms as a straight line slowly rising from left to right on a chart. Since it takes many years for fundamentals to change, their price impact is quite gradual.

But superimposed on top of these core fundamentals is the psychology of traders, which imparts great volatility to oil prices. Traders as a group perpetually oscillate back and forth between two emotional extremes, widespread greed and widespread fear. When they get greedy, they rush to bid up oil prices too far too fast. When they get scared, they scramble for the exits and drive down oil too far too fast.

This collective greed and fear pulls and distorts oil's fundamentally-driven straight-line secular-bull ascent. When greed reigns, oil prices are pushed too high relative to their underlying fundamentals. When fear reigns, they are pulled too low. So instead of a nice straight line, oil's secular bull has looked like a sine wave oscillating around a straight line. Greed eventually fuels big uplegs which get overbought and fail, spawning big corrections that soon get oversold and burn themselves out.

All bull markets experience these same upleg-correction cycles, created by the same ubiquitous greed and fear in traders' hearts. And as oil gets overbought and oversold, oil stocks amplify these moves in the commodity they produce. This reaction is certainly logical. Oil stocks have great profits leverage relative to the oil price, and it is profits that ultimately drive any company's stock price.

In recent months oil has weathered a major correction, one of the largest ones of its entire secular bull. With oil down so much, oil stocks have naturally been sold aggressively. This has pounded them to deeply-oversold levels very disconnected from the underlying fundamental reality that drives their long-term profits. Thus there is an amazing (yet fleeting) opportunity today to buy elite oil stocks at bargain prices.

While many indicators can measure overboughtness and oversoldness, reflections of excessive and unsustainable greed and fear respectively, my favorite is Relativity. I created this simple trading system many years ago to help hone my timing. It looks at prices relative to their underlying 200-day moving averages. Since 200dmas are slow to change, they are a perfect baseline from which to measure how far and fast any price has moved.

Relativity multiples are computed by dividing a price by its 200dma. Charted over time, this multiple forms a horizontal trading range. When a price gets too high relative to its 200dma, it is overbought so prudent traders ought to layer out and realize their profits. When a price falls too low relative to its 200dma, it is oversold so traders ought to layer in to buy low. Relativity reveals both oil and oil stocks were recently as oversold as they've been for years, an incredible buying opportunity.

Relative Crude Oil

2008's crazy stock panic was an epic discontinuity disrupting every commodity's secular bull, so it is most useful today to limit this analysis to the post-panic years. Since bottoming around the secondary stock-panic low in early 2009, crude oil has enjoyed two massive uplegs and weathered two major corrections. But despite this greed-and-fear-driven volatility, it has still clearly risen on balance as its bullish global supply-and-demand fundamentals require.

In its recent correction, oil surrendered nearly a third of its value after hitting its latest interim high in late April. A 32.4% correction certainly sounds gargantuan, but incredibly for usually-volatile oil it is not too exceptional. Back in 2003 and 2006, well before the stock panic in 2008, oil experienced even bigger healthy-bull-market corrections of 33.3% and 34.5%. So this particular commodity falling by a third or more certainly doesn't imperil its secular bull at all.

Interestingly, oil tumbled back down to some major support levels during its latest correction. Near $77 per barrel last week, it was again at prices first seen in this post-panic era in late 2009. And it also hit its major post-panic support line established during its last correction in spring 2010. So from a classic technical-analysis perspective, oil is definitely now trading around levels likely to spawn its next major upleg.

But absolute prices aren't particularly important for trading, relative ones are. And the Relative Oil (rOil) construct really drives home just how oversold oil has been. If you took oil's black 200dma line above and flattened it to horizontal, and then rendered the blue oil price as a multiple of that 200dma (which is perfectly comparable over time in percentage terms), the result would be the light-red rOil line slaved to the left axis. It has indeed formed a distinct horizontal trading range.

At Zeal we base these Relativity ranges on the latest 5 calendar years of price action. If you are a subscriber, you can log in to our website and see the large high-resolution charts (updated weekly) that we use to define our Relativity ranges. Crude oil's relative range now runs from 0.90x on the support side to 1.35x on the resistance side. In other words, oil tends to trade between 90% of its 200dma when it is oversold and 135% of its 200dma when it is overbought.

These oversold conditions are seen after normal healthy bull-market corrections. Late in oil's last correction in spring 2010, rOil fell to 0.906x. Ironically back then, traders were scared that a Greek default and China slowdown would somehow seriously retard global oil demand. Sound familiar? Yet technically oil was simply oversold, it had fallen too far too fast to be sustainable. And indeed over the subsequent 11 months or so, oil powered 63.9% higher in another mighty upleg.

During its latest correction, the oil fear was even more extreme so the resulting oversoldness was considerably greater. rOil didn't bounce at its 0.90x trading-range support, but kept on plunging. This key metric hit 0.845x in early August the day the S&P 500 correction initially bottomed, and 0.808x last week when the stock markets hit their marginal new secondary low. Oil was radically oversold both times!

In fact as this chart reveals, oil fell so far so fast that it was as oversold as it has been since emerging out of its secondary stock-panic lows in early 2009! And those lows were brutal, oil was merely trading at around $45 back then. Wouldn't you have loved to have gone long oil stocks as we did near those levels? I suspect a year or two from now, traders will wistfully look back at today's cheap oil and feel the same regret.

So because oil stocks' profits are determined by oil prices, and profits ultimately drive stock prices, oil drives oil-stock levels. And this Relative Crude Oil chart clearly shows that oil was hammered to prices that were as oversold as it has seen since emerging out of the stock panic in early 2009. With oil due for a major new upleg soon for its own technical and sentimental reasons, this is very bullish for oil stocks.

The flagship oil-stock index is now called the NYSE Arca Oil Index, but is better known by its classic symbol XOI. It was established 27 years ago and includes 13 major oil stocks with a mammoth collective market capitalization of $1603b at the end of July before the lion's share of the recent sharp correction. While the gigantic XOI components are much slower to move than the smaller higher-potential oil stocks we prefer to trade, it is still representative of this sector as a whole.

Relative XOI

Like the valuable and scarce commodity they bring to market, oil stocks have experienced two major uplegs and two major corrections in this post-panic era. This latest correction was huge by oil-stock standards, the XOI surrendered 29.1% in just 5.2 months. This selloff was so darned severe that it hammered oil stocks back down to price levels seen in mid-2009 when oil was trading around $60!

To give you an idea of how goofy this is fundamentally, in August and September 2011 during the recent stock-market bottoming process oil prices averaged $86 which was over 43% higher! And they never fell much below $77 at worst, fully 28% higher. Excessive fear drove the oil stocks to totally-irrational price levels far disconnected from their underlying fundamental reality. The XOI was beaten back to a super-low major-support line formed during this index's last correction in the summer of 2010.

In Relativity terms, the 5-calendar-year horizontal trading range of the rXOI now runs from 0.95x to 1.20x. The XOI tended to be oversold near 95% of its 200dma and overbought near 120%. This latest XOI correction was so massive that it pummeled the rXOI down to 0.789x early last week! Just like oil, oil stocks were as oversold as they've been since right after emerging out of the secondary stock-panic lows in early 2009!

After the XOI's last correction in summer 2010 which pushed oil stocks to far-less-oversold levels than seen recently, this flagship oil-stock index still powered 59.5% higher over the next 10 months or so. We bought smaller oil stocks aggressively during summer 2010's oversold conditions, and many of our trades more than doubled by early 2011. After oversold conditions in secular bull markets, major uplegs are born. And the more oversold prices get, the more potential the resulting buying opportunity has.

With both oil and oil stocks as oversold as we've seen since just after that epic once-in-a-century stock panic, today's buying op is amazing. With oil demand relentlessly growing globally as most of the world continues to industrialize, and large new oilfields ever-harder to find, oil stocks ought to bounce back rapidly from their deeply-oversold levels to reflect oil's bullish fundamental reality.  The brave contrarians who can steel themselves to buy low in this uncertainty are going to win huge gains.

Oil and oil stocks weren't just crushed in massive corrections because anything fundamental changed, but simply because excitable traders got scared. The second correction of the stock markets' post-panic cyclical bull plunged precipitously after Obama's profligacy triggered the first USA debt downgrade in history in early August. Commodities stocks got hammered with general stocks, but many commodities including oil remained relativity resilient at that time despite the stock selling.

But then in early September as the stock markets were bottoming, a terrible monthly US jobs report was released showing zero jobs created. This led economists to assume the US was plunging into a new recession. These mushrooming recession fears weighed on commodities and commodities stocks all last month, and were greatly exacerbated when the Federal Reserve failed to announce a third round of quantitative easing as some traders had hoped. Commodities and their producers' stocks just plummeted.

But not surprisingly, traders were far more scared than economic reality warranted. Hyper-oversold conditions in the stock markets and commodities (which I discussed last week) led them to assume the sky was falling. They feared that Greece is doomed, Europe is fracturing, China is slowing, and the US is facing a recession. But weak markets always make traders, economists, and analysts very pessimistic and bearish. They start expecting the worst at exactly the wrong time, after the bottoming is underway.

Ironically, the jobs report that initially ignited all the recession fears was just revised way higher by the US Labor Department. Last Friday it said that August jobs growth wasn't really zero as originally reported, but much better than the expectations at the time (+57k). So the fountainhead of the recession fears was retroactively revised upwards, leading economists to double the US economic-growth forecasts that they had halved on that original bad jobs report.

The deeply-oversold levels in oil and oil stocks we've seen in recent weeks were an anomaly driven by excessive pessimism and bad data that no longer exists. As always after major corrections, fear got out of hand. It so blinded the majority of traders that they started pricing in an apocalyptic slowdown in the global economy that was never in the cards. And oil and oil stocks got trapped in this fear crossfire.

Considering how terrified traders became over the worldwide economic prospects, it was actually pretty impressive how high oil prices remained. And if oil demand stayed high enough so oil could trade between $80 and $90 when the markets were trying to price in a new panic, imagine how high oil will surge as those economic fears inevitably fade. The potential gains in oil and oil stocks are enormous.

At Zeal we've been aggressively buying oil stocks throughout this fear-laden bottoming process. It is never easy fighting the crowd, adding new trades when everyone else is scared. But during such ugly oversold conditions is the ideal time to buy low, a necessary prerequisite to selling high later. We did this during the last oil and XOI correction in the summer of 2010 too, and were richly rewarded with huge realized profits just 6 to 9 months later. But which stocks to buy?

We just finished a 4-month deep-research project investigating the entire universe of mid-cap oil stocks trading in the US and Canada. We gradually whittled this list down to our dozen favorites fundamentally, which are profiled in depth in a fascinating new 36-page report. These elite mid-cap oil stocks have amazing fundamental prospects, and are trading at oversold levels like their larger peers. For just $95 ($75 for subscribers), you can enjoy the profitable fruits of hundreds of hours of expert world-class research. Buy your report today and get deployed in cheap oil stocks!

We also publish acclaimed weekly and monthly subscription newsletters. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, and how to trade them with specific stock trades as opportunities arise. Our contrarian trading, buying when others are scared and selling when others are greedy, has been wildly successful. Since 2001, all 591 stock trades recommended in our newsletters have averaged annualized realized gains of +51%! Subscribe today and start thriving!

The bottom line is oil stocks were just driven to deeply-oversold levels. Excessive fear spawned by a healthy-yet-sharp stock-market correction, combined with since-revised-away economic data, convinced traders a new global recession was brewing. So they rushed to dump oil and oil stocks, driving each to their most oversold levels seen since early 2009 as they emerged out of the secondary stock-panic lows.

But oversold levels never persist for long in an ongoing secular bull. As the irrational fear that spawns them inevitably passes and fades, oil and oil stocks will be bid back up to prices reflecting today's bullish fundamental reality for this crucial commodity. Contrarian traders who steel themselves to fight the herd and buy low when everyone else is scared are going to enjoy huge oil-stock profits in the months ahead.

 


 

Adam Hamilton

Author: Adam Hamilton

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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