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Energy Sector Bottoming Out

We are watching oversold crude oil prices building a bottom 

Crude Oil ReturnsSource: Short Side of Long

It is not easy to stick your neck out and make a major call on an asset class, but we here at Short Side of Long have done it in the stock market on 25th of August. About a week after that call, we also gave our readers heads up as to why we think commodities are finally close to forming an important low. Finally, just before the month of October started, we discussed the potential for a precious metals rally, anticipating a falling probability of FOMC hiking rates in 2015.

One of the major stock purchases we did in both late August as well as late September were the beaten down energy stocks (NYSE: XLE). We jumped at great value and very high dividend yields in individual names such as ConocoPhillips (NYSE:COP) and Chevron (NYSE: CVX) amongst others, as well as the overall Oil & Gas sector (NYSE: XOP). Reasoning behind this purchase is our view that Crude Oil has most likely bottomed, together with the fact that Energy stocks suffered one of the worst bear markets and liquidation panics in two decades.

August panic in the energy stocks was 2nd worst in two decades

Energy Sector 52 Week Lows Source: SentimenTrader (edited by Short Side of Long)

The type of a liquidation we saw in Crude oil throughout 2014/15 period has certain similarities to other historical crashes from 1986 and 2008. Both of these are selling climaxes, and once the bottom is reached one should buy all they can. We finally see a change in supply & demand dynamics, with oil rig count rapidly declining in recent quarters, which almost guarantees a noteworthy fall in future supply. Furthermore, corporate insiders (smart money) have been busy buying energy stocks, while hedge funds & speculators (dumb money) are extremely bearish with worst sentiment reading in two decades.

During the 25th of August, now also known as Black Monday, market participants reached a boiling point, as they completely dumped energy stocks. Percentage of components in the S&P Energy sector (NYSE: XLE) spiked over 75%, which was the second worst selling climax, only outdone by the Lehman panic of October 2008. Furthermore, percentage of energy components trading above the 200 day moving average has been depressed (oversold) for the longest stretch in almost two decades. We haven’t seen neutral readings (above 50%) in over 52 weeks, which shows just how incredible the selling pressure in this sector has been.

Energy sector has been in a strong bear market for over 14 months

Energy Sector Below 200 MASource: SentimenTrader (edited by Short Side of Long)

We believe capitulation has occurred, as the whole energy sector turns a corner. As Oil prices stabilise and start their road to a recover, Oil & Gas earnings should finally start to improve while dramatic cut costs will make the overall sector more lean and competitive. Thanks to SentimenTrader for great charts, which we slightly edited for better presentation.

More Signs Of Pessimism Is Bullish

Further evidence of pessimism as fund managers cut net long exposure

NAAIM Net Long ExposureSource: Short Side of Long

Problems with VW and Glencore, poor seasonality, technical damage, slowdown in EM economies and a disappointing jobs report did not manage to knock the market down. Whenever an asset refuses to make new lows on deteriorating news and tape rallies strongly in the opposite direction (just like Friday’s technical reversal), it is a very bullish sign. On the 01st of October, we were discussing a possibly of a double bottom, which now seems to have above average chance of completely developing.

We have already discussed how breadth became washed out and sentiment dropped to extremely low levels. New data showed that yet another indicator registered an important buy signal late last week: National Association of Active Investment Managers. As we can see in the chart above, net long exposure by fund managers has now dropped below 20% for only the second time in the last four years. Only other time was October 2014, which also marked an intermediate bottom.

Traders have been busy purchasing plethora of put options recently

Put Call Ratio Source: Short Side of Long

Furthermore, by late August, we saw how options trades pushed the VIX to the second highest daily reading in almost three decades, prompting us to call a capitulation bottom. These same trades have continued to load up on put options throughout majority of September, with the hope that the index will break towards lower lows. Assuming that the S&P 500’s double bottom  and Friday’s outside reversal (biggest in 4 years) holds, plethora of put purchases could end up being a strong contrary signal.

Finally, global fund managers are extremely worried and fearful of the Chinese economic slowdown and a potential for a full blown emerging markets debt crisis. I feel that whenever certain “investment mantra” reaches a boiling point as in being front page of every newspaper for several months, central talking point of almost ever fund manager interview and most popular blogging theme across internet… its most likely overdone with a reversal in the cards. The fact is, MSCI EM Index has refused to make lower lows despite continual bearishness ever since the emotional wash out occurred during the Black Monday 25th of August.

Global managers remain most worried about Chinese & EM growth

FMS Tail Risk

Source: Merrill Lynch

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