The contrarian in me is checking out the Energy Sector

The past couple of months have not been kind to the S&P 500 Energy sector. With the price of oil in a free fall, investors have been scrambling for the exits as energy stocks are decimated. This brutal trading sequence intrigues us.

With our interests piqued, we have been monitoring the sector and are positioning ourselves to take advantage of some of the value that is being presented. While we are reviewing several stocks in the sector, we thought it prudent to go over a few sector models that we are drawing our investment thesis upon. We are using The S&P 500 Energy SDPR (XLE) as our underlying instrument

We us a proprietary tool that we call the Behavioral Momentum indicator. This model is similar to a relative strength number but incorporates volume. It is this investors humble opinion that price can represent the logic of a trade while volume is the emotion.

This model takes the average volume for the past 90 days of “up” days vs. “down” days to create a relative strength figure. We then run a z-score for the time series to measure dispersion from the mean. Understandably this is a contrarian indicator and any period falling below two standard deviations from the mean indicates a sector that is behaving badly and is worth further consideration.

Historically, when a specific sector sees an aggressive decline and the model reaches -2 it offers an opportunity to start building positions within the space in the hopes of profit. As seen in the first figure, in August of 2010, XLE sold off to approximately $49 adjusting for splits, down from a near-term peak of $57 a few months earlier. A fairly dramatic 14% drop. The BM model raised a convincing argument that sentiment around the sector was near its lows. The ETF went on to rally to $65 by year end, a +30% move.

We saw a similar situation in August 2011. XLE sold off to around $60 per share but later gained 20% to $72 in about five months. Once again in June 2012 XLE was trading at approximately $62 per share when the BM indicator registered extreme pessimism. This turned out to be a wonderful buying opportunity with the ETF running up to $100 per share over the next two years.

As one can see, the BM indicator is telling us that this may be the appropriate time to start looking at the space for possible investment.

Two other technical indicators that we find useful are the percent of stocks in the ETF trading below their 50 day moving average and the percent of stocks in the ETF with a bullish point and figure pattern. When used in conjunction with the BM indicator, these models offer confirmation of those entry points mentioned above. Currently only 9% of the stocks in the XLE ETF are trading above their 50 day moving average and the bullish percent P&F patterns (expressed as a z-score) has come way down. Both models are confirming a possible entry point for XLE at these levels.

One last item that we tend to watch for confirmation is the Volume Momentum Oscillator. It is defined by stockcharts.com as, “derived from the McClellan Volume Oscillator which is calculated the same as the McClellan Advance-Decline Oscillator, except it uses a ratio of Advancing Volume to Declining Volume instead of Advances and Declines. Specifically, subtract NYSE Declining Volume from Advancing Volume, then divide the result by NYSE Total Volume. Next multiply that result by 1000 in order to work with whole numbers:

((Adv Vol - Decl Vol) / Total Vol) * 1000

The rest of the calculations are the same as for the McClellan Oscillator and ITBM: add the daily McClellan Volume Oscillator (Ratio-Adjusted) to the daily 10% exponential average (Ratio-Adjusted), then calculate a 20 day EMA.”

We then express it as a z-score for simple reading. As with the other models, this too has acted as confirmation to our BM indicator and is giving us the same buy signals as the other models.

Bottom Line: Step one is our “target” phase. We have targeted the energy space as a potential investment opportunity and next week we will be reviewing step two of our process which is the “trend” phase. Using our fundamental models in for the sector, we will select what we believe are the stocks that will benefit the most from our investment thesis.

Please stay tuned…

Joseph S. Kalinowski, CFA