A Major Low in Natural Resource Stocks
By Frank Barbera CMT. October 5, 2006
Yesterday, we saw an unusual phenomenon unfolding in the markets, as Natural Resource stocks, under heavy selling pressure of late, plunged in a selling climax and managed to end the day higher. In some cases, the daily swing reversal seen on individual stocks exceeded 5% from low to high with a number of resource related industry charts putting in a key reversal day which came on very heavy trading volume. This is normally a very good sign that prices are in the process, or have made an important low. What’s more, today’s action did not produce a key reversal day in just one sector, like say the Gold Stocks, but in share prices across the entire spectrum of natural resources from Oil Producers, to Oil Drillers, Infrastructure to Refiners to Natural Gas, Alternative Energy to Coal Stocks to Tanker stocks, --- the reversal patterns dominated.
In our work, in addition to tracking just Gold, we track a wide number of other sectors, and we watch those sectors from an amalgamated point of view. In what we loosely call our “Stagflation Index”, (because resource stocks tend to do well in periods of stagflation) we have placed approximately 150 key resource oriented stocks, into an index that is based on several major market resource segments. These are: Gold and Silver, Coal and Alternative Energy, Integrated Large Cap Oil, Small and Mid Cap E&P Oil Producers, Natural Gas producers, Refiners, Base Metals producers, Infrastructure and Engineering, Energy Transportation, and Energy Services. The chart on the top of the next page shows this index going back to 1994 with its 200 day trading bands. Between yesterday and today, this index came down to, and reversed up off its lower 200 day band for the first time since mid-July 2002 — over four years ago!
At the same time, the Medium Term ARMS Index has spiked fully into ‘major bottom’ territory over the last few days with a peak reading of 1.78 on Tuesday. Historically, these types of huge readings indicate fear and the presence of a major low, which in this case appears to be completing for the entire resource sector. What about other indicators for the Stagflation Index. ? Like the Gold Stocks, we also track the McClellan Summation Index for the broad list of 125 “resource names”. Guess what we are seeing right now on the Summation Index ? Any guess ? Well, the answer is huge evidence of a major low. In order to illustrate this point in gross detail, we are going to take subscribers through a few charts of the Summation Index which are rather subtle, so we ask for your indulgence for just a moment. On the first chart atop the next page, we see the “basic” Summation Index for the Stagflation Index which closed today at a reading of +288.25. Now, historically, this indicator was set up to oscillate back and forth between +2000 and zero, so a bear could argue, “hey, we are not below zero, we are still only at +200 — so the indicator is not that oversold”. Ah… but wait just one darn moment, as there is more evidence too consider. You see, the Summation Index like all technical indicators tends to experience some degree of what I call “scale shift” depending on the primary trend of the market. For example, in 1998, the Resource sector as a totality was in a super bear market, and the Summation Index reflected that by plunging to record lows, -- a reading of -1380.43 on 09/02/98.
Above: the Basic Summation Index for the broad Resource Sector
Above: the Summation Index for the Resource Sector with relative trends illustrated.
In the second chart above, you see the -1380.43 reading of Sept 2, 1998 highlighted by the lower right facing arrow at the bottom of the chart near the indicators 1998 all time low. That was the depths of bear market fear. Next, I have drawn in an arrow at the next major overbought high which peaked at +1818.90 on May 6th, 1999. The total swing in the index from the 9/2/98 low to the subsequent 5/6/99 peak was 3,199 points, with 3,000 points in about a year as big a swing as we ever see. Note, that following the record oversold reading of 9/2/98, the index never quite made it back to fully overbought values at +2,000 or higher with the 5/6/99 reading peaking at +1818.90, just under 2,000. Next, I want to point out that almost dead center in the middle of the chart, we saw the Summation Index swing from a high at Point X of +2,541.10 on 04/02/02 to the low at Point Y on 07/26/02 at —745.77, we once again saw an extreme Summation Index swing totaling 3,286.87 index points.
Next, we shift our attention to the right side of the chart above and note that the Energy Bull market of the last few years, succeeded in pushing the Summation Index to an extreme overbought reading, equal and opposite to the Bear Market extreme oversold reading seen in 1998. In the case of the Bull Market extreme, the reading was seen at +3090.12 on March 8th, 2005. As is the case with the Summation Index, which is a long term breadth indicator, the peak breadth always is seen long before the high in prices. That said, from the high of +3090.12 in March 2005, to the June low at +321.29 on June 20th, 2006, we once again saw a nearly 3,000 point swing in the Summation Index totaling +2,768.83 points. Thru this weeks lower low of +210.47, that swing is even closer to 3,000 points at +2,879.65 and just as the extreme bear market oversold reading seen in September 1998 was followed by a subsequent overbought value that failed just below +2,000, so too is it logical that the extreme overbought readings of March 2005, should be followed by a set of oversold readings that fall just shy of the fully oversold benchmark at zero. But ah… there is still more….
To quote one of my favorite chefs, Emerile Lagasse, we can “kick things up another notch”. To do that we want to use a moving average to give us a relative sense of how far the Summation Index has moved around its relative mean. If the underlying stocks have been in a bear market and the index is deeply oversold, we want to ask the question, how far away from the mean (the moving average) are we ? Conversely, if the underlying index has been in a bull market, and we have had a correction, again, we ask how far are we below the mean ? To do this, I am using a 500 day moving average, which is almost a two year period of time. Around the 500 day Moving Average (middle band), I then plot upper and lower Bollinger Bands set at 2 Standard Deviations which encompasses
95% of all the data. The result is shown in the chart above where low and behold, we see that the Summation Index is well outside its 500 day lower band. Note that the same “giant” excursion below the 500 day lower band was seen back in 1998 and in mid-2002, both “towering” bottoms for the resource sector. Yet, our analysis is still not complete. We can go one step further. To do this, we use a simple formula which plots the daily close of the Summation Index less its 500 day moving average, versus the Band Width or Upper Band minus the Lower Band as shown in the formula below:
Detrend Oscillator = (Summation Close) less (Moving Average)
(Summation Upper Band) — (Lower Band)
By doing this, a process called “detrending” we can directly compare the degree to which in precise terms the Summation Index is above or below its upper or lower extremes (i.e. trading bands). What we see in our final chart is simply stunning. Namely, we find that whenever the Summation Index is more than 5% above its upper band, or 5% below its lower band prices tend to be near a major extreme. At truly major lows, it appears that for brief periods of time, prices can force the Summation Index about 6 to 7% outside the bands as was the case at the July 26th, 2002 lows a —7.74%, the July 18, 2001 lows —6.23%, the 9/1/98 lows —7.45%, the 1/12/98 low a —6.83%. Where are we now ? Well, as recently as Friday — September 25th, the Summation Index for the Resource Sector closed at a reading of 7.12%, with a reading today of —6.38%. Even more importantly, the 200 day moving average for the Stagflation Index (upper chart) is still rising —albeit flattening out). In the past, this type of —7% reading cast against the backdrop of a rising to flat moving average has always resulted in sharp rallies. In the only two instances where big rallies did not materialize, the moving average had already turned down for quite some period of time.
As a result, we believe that “in relative terms” the entire resource sector defined to include both Metals and Oil, is very likely about as oversold as it is “ever likely to get” and therefore, squared up against the presence of the 200 day lower band support (top clip) is very likely to rally sharply off of the now completing major bottom. Before leaving the Stagflation Index and the broad resource sector, we also wanted to add in to the mix our Money Flow Oscillator based on Up and Down Volume for the Stagflation Index. This medium term gauge is also deeply oversold and is now sporting a positive divergence with regard to the June lows. On the next page, we show the long-term chart of this gauge going back to October 1995 with extreme overbought and oversold values at +15% and —15%. The final chart shows a close up view of the indicator clearly showing the slightly lower October low, versus the June low in the price index and the decisively higher lows on the indicator in early October versus the absolute lows seen in June. Technically, this is a classic positive divergence and strongly suggests that the decline in the Natural Resource sector is either already complete, or in the in very final stages of completing. That’s all for now.
Above: Long Term Money Flow Osc. And Below: Close up view showing positive divergence to signal a final low.
© 2006 Frank Barbera