It’s hard to look at the charts throughout energy and materials and question the outlook for global growth. On the cusp of a meaningful breakout just a month ago, the reversal in energy has been violent and has left a fair amount of damage in its wake. I had been intrigued with the sector since last summer, as the internal capitulation coupled with bearish sentiment seemed to dovetail nicely with the constructive trends in oil. The sector is once again oversold, but one should not ignore the recent technical damage, the commodity included. The question is, will this be an oversold rally that you want to sell? If the ensuing rally is meek in nature and lacks the usually bullish momentum that has accompanied rallies since last summer’s low (the rally off the October 29th low would definitely fall into this camp so far), I’ll have no choice but to reverse what has been a constructive view.
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I’ve always discussed that how a particular financial asset responds to an oversold condition to be of critical importance. In a strong uptrend, bulls capitalize on the opportunity at hand, quickly taking advantage of the mispriced asset. The same can be said of overbought environments within a downtrend, as sellers take advantage of the countertrend move. I mention this because the energy sector’s oversold response in the six weeks since the February low has been frustrating, to say the least. Upward momentum has been noticeably absent, while relative performance grinds to fresh lows on an almost daily basis. The good news – this digestion is occurring above support, but the clock is ticking for momentum to present itself.
While we were looking for a healthy upward move, we have to admit that we are more than impressed with the Energy sector’s 10% move out its late August oversold condition (Tradable Low for Energy?). Now the real work begins, as the sector faces stiff overbought signals across the board. There is no denying the questionable nature of the sector’s longer-term trends, but countertrend rallies can persist, especially when coupled with bearish sentiment. While overbought conditions in a downtrend are usually excellent selling opportunities, given the momentum behind this recent move and the improvement in the oil chart, we’re reluctant to cut bait too soon. Keep stops tight, but I believe this rally has some more to go.
Since the peak in the energy sector back in 2014 we have been constantly on the lookout for signs of a sustainable trend change. It’s not atypical for a sector that has just completed a major bear market (think of tech post ‘02 or financials after ’08-09) to languish for years before investor wounds and their scar tissue have completely healed. Energy has tried on multiple occasions, but each attempt has failed over the past 3-years. We’re constantly on the lookout for momentum and relative performance to confirm, but for the most part, all we have experienced since the peak has been a bunch of head fakes. Once again the sector is trying to steady itself following a deeply oversold condition, albeit within a downtrend, as 20-day highs have expanded to the highest level since December. Absent the broad market’s rally off the lows last February, pressing longs when 1-month highs are expanding coming out of an oversold condition has been a losing proposition (red arrows). Needless to say, we’re not convinced that the lows are in.
The unrelenting oversold condition in Energy is a great example of why trying to bottom tick a downtrend can be a particularly frustrating and money losing proposition. With crude finally gaining some near-term traction at support, the question we continue to receive from clients is whether it is time to aggressively take advantage of the equity pullback. Unfortunately, the various pieces of our process tell us it’s too soon. Technically, the stocks and the underlying commodity look like they want to head lower, while cracks are beginning to appear in credit. Refiners continue to be the best bet for relative performance within the sector , but we’ll be the first to admit that the group is in for a sharp reversal if our broader concerns around the sector fail to come to fruition and the oversold condition gains meaningful traction.
While equity trends continue to be constructive, catching up on the charts over the past few days, one thing in particular really caught our eye since we last published a little over 5 weeks ago...the bond market. While yields are fighting the good fight at 2.15% support, the curve has collapsed, and is now the flattest it has been since October of last year. Growth as a style had clearly become extended versus value, and while a reversion in both is to be expected, we have a tough time believing that value can post meaningful absolute and relative performance without bonds cooperating.