November 10th, 2014
by Lance Roberts, StreetTalk Live
This past week I asked the question "Is Energy Ready For A "Dead Cat" Bounce?" To wit:
"The recent melt-down in oil and energy related stocks are something that I warned about in early August of this year when I wrote:
'Analysis: Massive Divergence Not Healthy
While oil prices have surged this year on the back of geopolitical concerns, the performance of energy stocks has far outpaced the underlying commodity.tyle="font-size: medium;">The deviation between energy and the price of oil is at very dangerous levels. Valuations in this sector are also grossly extended from long-term norms.
If oil prices break below the consolidation channel OR a more severe correction in the markets occurs, the overweighting of energy in portfolios could lead to excessive capital destruction.
While the argument has been primarily focused on the"yield chase,"the"price destruction"will far outweigh the desire for income. It is a good time to take profits in the sector and reweight portfolios back to target goals.'"
"Each following week during the entire reversion process, I kept warning that things would get worse for both the commodity and the energy sector as the supply/demand imbalance grew as deflationary pressures circled the globe. Those predictions have come to a rather painful realization.
The good news is that the selloff in oil has gotten to extreme levels. The extreme decline should allow for oil prices to experience a rather significant "dead cat" bounce. This is shown in the chart below, where previous plunges to current extremes have resulted in a rather significant bounces back to at least the previous trend line break. (I have used performance to keep the scale in proper alignment)"
As I have discussed in the past, price movements in markets are constrained by their long-term moving averages. Prices cannot remain permanently above or below their long-term average otherwise the moving average would be different. For example, it is mathematically impossible for 80% of all drivers to be better than the average, yet this is what people think.
Over long-term time frames prices both rise AND fall. When prices rise or fall extreme distances from their underlying average, the gravitational pull of the moving average will drag prices back. The example I most often use is that of a rubber band. When a rubber band is stretched to its extreme and is released, it will snap back an equal distance in the opposite direction. This is what happens with prices over time. The chart below is a monthly chart of the S&P 500 as compared to it 36-month (3 years) moving average.
First, notice that while prices do remain above the moving average for long periods of time the reversion process has been extremely damaging. Secondly, the current bull market extension above the long-term moving average is at levels (24.5%) not witnessed during the prior to financial bubbles in the market.
Like a rubber band, when the market snaps back the reversion process will be just as damaging to the downside as it has been previously.
Another measure of extreme deviation is by looking at standard deviations. As I discussed in more detail back in September of this year:
"Standard Deviation is defined as:
'A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.'
In plain English, this means, and as shown in the chart below, is that the further away from the average that an event occurs the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside of the area of three standard deviations. 95.4% of the time events will occur within two standard deviations.
For the stock market - one way that standard deviation is measured is with Bollinger Bands. John Bollinger, a famous technical trader, applied the theory of standard deviation to the financial markets.
Because standard deviation is a measure of volatility, Bollinger created a set of bands that would adjust themselves to the current market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).
The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. This is shown in the chart below.
The dashed red line is the 30-week moving average (or mean) with solid red lines representing 2-standard deviations above and below the mean. As shown in the bell-curve chart above, 2-standard deviations encompass 95.4% of all probable price movement. This suggests that currently there are only 46-out-of-1000 chances that the market will move substantially higher from current levels.
Important, if you will look closely at the chart you will see a repeated cycle that when the market has reached extreme deviations it has been a point where rallies or corrections have followed.
Analyzing Oil And Energy
With the understanding given above, we can now apply that analysis to oil prices and the energy sector. As I stated above, the current sell-off in oil prices and energy stocks has gotten a bit extreme as below.
Oil is currently trading more than 20% below its 36-month moving average and is currently 3-standard deviations below its 30-week moving average. As shown in the bell-chart above, this represents fully 99.7% of all potential price movement in that direction.
With the long-term moving average sitting at $96.5, a "bounce" in oil prices could be quite significant. However, such a bounce should be used as an opportunity to REDUCE weightings in oil related investments at that time. As shown below, the breakdown out of a long-term consolidation pattern suggests that prices are moving lower. Based on the current supply/demand backdrop my best guess is that $70/bbl is likely to be a near term low for now. If the global deflationary pressures continue to gather traction then lower oil prices, as identified by the lower (green) support lines, are realistic probabilities.
However, since most of invest in energy companies as opposed to purchasing oil directly, we can apply the same analysis to companies in that sector. I am using the Energy Select Sector SPDR as a proxy for the energy sector.
As opposed to oil prices, energy stocks bounced from their 36-month moving average as identified by the red arrows. With the sector getting extremely oversold recently, pushing 3-standard deviations, the bounce back should be rather sharp. Currently, the bounce should take energy stocks back to their current 30-week moving average at $93.74. IF, a bounce of that magnitude occurs I would be a seller of energy stocks at that level.
As shown in the chart below, when stocks get extremely oversold and bounce back, that is usually ONLY the first leg of the corrective process. As in 2011, the selloff during that summer took energy stocks to their lows, where they then rallied back. Investors who failed to take action suffered a retest of previous lows just months later.
I have identified what a similar rebound, selloff, and buy pattern would look like in the chart below.
I am becoming much more pessimistic about oil in the near term as global deflationary pressures continue to rise. As I addressed recently, the supply/demand imbalance is growing rapidly as production is rising, and demand is declining.
"First, the development of the"shale oil" production over the last five years has caused oil inventories to surge at a time when demand for petroleum products is on the decline as shown below."
"The obvious ramification of this is a 'supply glut'which leads to a collapse in oil prices. The collapse in prices leads to production"shut-ins,"loss of revenue, employee reductions, and many other negative economic consequences for a city dependent on the production of oil."
For now, any bounce in oil prices, and subsequently a bounce in related energy positions, should be used as an opportunity to underweight this sector in portfolios. That is until the bullish trends reassert themselves at some point in the future.
Have a great weekend.
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