Tuesday, December 23, 2008

The Technicals Say Buy Oil

Investors can debate the fundamentals of the price of oil, but several key technical analysis indicators point strongly toward a buy recommendation.

To begin, let’s be clear with the fact that, from a technical analysis perspective, the mega trend for oil (and the entire energy complex as well as nearly all equity categories, for that matter) is solidly in the bearish category. This is evident in the first chart (click image to enlarge) as price is below its moving averages (50 and 200 day), moving averages have crossed to the downside (50 below 200 day), and both moving averages point downward*. This signifies that any rebound in the price of oil must be viewed as a bear market rally. That said, the technicals that support buying into oil at these price levels are the near and short term indicators tracked – Momentum, MACD, and Slow Stochastics.

The near-term indicators, Momentum and MACD, are the first two sections below the price and moving average data in the first chart. What they show is that the price of oil is producing a bullish non-confirmation low, as neither Momentum nor MACD are confirming with a lower low. It should be noted, however, that it would be better if the MACD lines were not so close to converging as it is necessary for both Momentum and MACD to in the bullish non-confirmation category. Nevertheless, since Momentum is producing such a strong non-confirmation signal and the slope of the MACD lines are upward, any upward movement in price will generate a reaffirmation of the upward trend in MACD and both lines should turn up.

The short-term indicator, Slow Stochastics, provides added support to the buy call as it has entered oversold territory (a below 20 reading), an area which produces many short-term trend reversal calls.

The second chart is interesting as it provides some backdrop to the price of oil and the energy stocks. You will note that as the price of oil was racing ahead in this past summer, the energy stocks did not follow suit. This was a clear warning sign that the commodity traders, heavily influenced by speculators, were behind much of the inflated price levels, prompting those with a less skeptical mind to predict $200 a barrel. Today, we have the mirror image of a few months ago with the price of crude making new lows while the energy stocks hold up quite well. This suggests that the current rationale of demand destruction ignores the very influential fact of speculative liquidations as the asset class advocates of earlier this year head for the hills and dump what they loved just months ago.

There is one additional dynamic that bears noting. The relative strength data you see in the second chart can also be seen in the third chart, which compares the energy group with the S&P 500. The third chart highlights why relative strength analysis involving assets that are heavily influenced by the price an underlying commodity (in this case, oil) can produce a misleading reading of relative strength. In other words, it is a mistake to ignore the underlying commodity in evaluating the relative strength of an equity index (like XLE) vis-à-vis a broad market index like the S&P 500.

Investment Strategy Implications

Oil is so out of favor that the contrarian (not to mention the longer-term investor) in me says maybe it’s time to go against the crowd, especially when the crowd in so consumed in fear and irrational behavior.

As I said at the top, investors can debate the fundamentals of the price of oil. Investors are free to buy into the depression/deflation scenario if they wish. And along with that thinking, investors are free to join the $20 a barrel club, just as they were free to join the $200 a barrel club. However, when groupthink gets so entrenched AFTER a significant price fall AND when the product in question is central to the functioning of the world economy (green dreams notwithstanding) AND when global growth will slow but not plunge into a black hole of never-ending pessimism, good contrarian investors look for signals that say maybe, just maybe, the crowd is wrong once again.

Disclosure: Accounts managed by Blue Marble Research have positions in XLE, IEZ, and USO.

*This is the Moving Averages Principles that has been referenced on numerous occasions in the past and applies to both bullish and bearish directions.

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