Waves versus Bases
Building a Bottom in Energy Stocks
Two Oil Stocks to Watch
One thing I've noticed in my 15-plus years working at Cabot and talking to hundreds of subscribers is that most investors think of the market in what I'll call waves. What I mean is that they view a stock as either going up or going down-i.e., the stock went from 10 to 25, then back to 19, then back up to 31, and so on. Waves going up and waves going down.
By no means is there anything wrong with that way of thinking. Carlton Lutts (our founder) was much the same way, viewing a stock or market's trend as either up or down. And it certainly worked for him.
However, I tend to look at market movements in a "stairstep" or "base-building" framework. In a stairstep or base-building framework, a market is basically headed sideways ... building a base (or a stairstep) before embarking on its next trend.
This base-building framework comes in handy in many facets of chart reading, but none more important than looking at sectors or indexes that are trying to bottom out after severe declines. (Important note: Declines of 10% or 20% don't count-I'm talking about 40% to 60% crashes.)
To the "wave" investor, a stock or market hits a bottom and that is the ideal time to buy. But to me, bottoms (and tops for that matter) are a process, not an event-especially following a major move.
For instance, consider a sector that has crashed in recent months, fallen 40% to 60% over a few months' time. Such a decline will almost always lead to a prolonged period of bottom building. And the reason isn't hard to understand-it takes time for the smart money to accumulate positions, and it takes time for the weak hands to lose hope and get worn out. This process will usually take a least a few weeks if not months.
A classic example was the market bottom in 2002-2003-the S&P 500 fell 50% from March 2000 through July 2002 ... 28 months of melting down. So could you expect the S&P to bottom and head higher from there? No way! It needed time to bottom out.
Sure enough, the S&P 500 re-tested that same level in October of that year, and then did it again in March 2003! That final bottom was THE bottom, but notice how it took seven months of rallying and re-testing to put in a firm foundation.
This sort of bottom-building action occurs most often when a sector or major index falls 40%-plus over many months-I would say eight out of 10 times at least, likely more.
I write about market's bottom-building in this Wealth Advisory because I continue to field a bunch of questions surrounding energy stocks. Have they bottomed? Is it too late to sell? Too early to buy? And so on.
For the past few months, my answer was rooted in what I wrote above-the S&P Exploration and Production ETF (XOP) fell 50% from mid-June to mid-December last year. So in the weeks that followed, I always said something like "the odds of a bottom and straight-up move are low at this point; the sector is going to need time to bottom out, if this even is the bottom."
Today, though, I'm increasingly intrigued by the group's action. It's now the end of March, and XOP has managed to hold those December lows (except for a very minor foray to new lows in mid-January) ever since. That means energy stocks have been bottoming out for about three and a half months now, and the recent dip has (so far) bottomed at a much higher level (45.8, versus under 42 in January and December).
My gut feel says the group still needs more time to flush out the weak hands-the 200-day moving average is still above 61 and falling fast, and usually after a major bottom is in, the group will start at or close to its 200-day line. (See the S&P 500 example above.)
Still, the fact that the group has stabilized for the better part of four months after a terrible crash raises the prospect that a meaningful turn for the better could be in the cards.
To be clear, as a growth guy, I am rarely interested in pure commodity stocks, as they lack great growth stories. But I'm also a student of the market, and any upturn in the energy sector could produce some very solid winners in time.
The good news is that there's no rush-as I wrote above, my gut tells me that, even if the group has bottomed, the lift-off point might take a bit. And another piece of good news is that, when a sector like energy is trying to bottom out, it's easiest to spot the stocks that are super-resilient.
Right now, I see two names to watch.
The first is PDC Energy (PDCE), which is operating in the still-lucrative Wattenberg Field (Colorado) and Utica Shale (Ohio) locations. Despite slashing CapEx spending this year, it expects production to surge 50%, and cash flow should be very healthy due to some excellent hedging activity. The stock is perched above its 200-day line and has shown multiple big-volume accumulation clues in 2015.
The second is Diamondback Energy (FANG), which is making hay in the Midland Basin (part of the Permian Basin in Texas). Amazingly, in a big chunk of its acreage, the net return from new wells drilled spans from 50% to 125% ... even at $50 oil! Shares rallied about 50% after bottoming in mid-October and are just shy of their 200-day line here.
Of course, there are other oil stocks that look decent, though I'm not touching any of them here. But should oil stocks kick into gear in the weeks ahead, these two (and, likely, many others) should have good runs for a couple of months, if not longer.
Chief Analyst, Cabot Market Letter
And Cabot Top Ten Trader
P.S. Now is the Time to Stay off the Sidelines
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