Energy Stocks' Relative Strength Hits 20-Year Low—What's Next?

Energy stocks have arguably been the weak link of the stock market. With the sector bruised, some contrarian traders may begin to wonder if the retreat is a buying opportunity.

Within the S&P 500 (SPX), the energy sector has chalked up the worst performance across all sectors over the last 12 months. It logged a 23.2% decline versus a gain of 7.6% for the broad index, according to S&P Capital IQ. In fact, the S&P Global 1200 Energy Sector index is at its lowest on a trailing 12-month relative strength basis since data collection began December 31, 1994. Relative strength compares a particular sector to the price change in the overall S&P 500.

"The energy sector has really taken it on the chin and some opportunistic investors are wondering if now is the time to buy energy," said Sam Stovall, chief equity strategist at S&P Capital IQ. "For those who believe in a reversion to the mean and have a long-term time horizon, probably yes.”

Earnings expectations may justify that stance. Energy sector earnings per share are forecast to decline 55% this year, but show a 32% increase in 2016, S&P Capital IQ says.

Entrée With Two Sides

Other traders might stick with diversification, for instance pairing energy with technology and consumer staples to model the S&P “free lunch” portfolio, Stovall adds. The free lunch strategy refers to a hypothetical portfolio of one-third consumer staples (a defensive sector), one-third technology (cyclical), and one-third energy (a late-cycle inflation hedge sector).

Since 1990, the free lunch portfolio is up 8.7% annualized versus a 6% return in the S&P 500, Stovall says. The strategy is based on its components’ low correlation, meaning when one zigs, another ideally zags.

“They also tend to perform best in different phases of the economic cycle," he explains.

Crude Breakout Bubbling?

It’s also important to drill down to the underlying commodity that drives energy drillers, refiners, oil-field service providers, and more. The crude oil futures market has settled into a narrow, sideways trading range in recent weeks, begging a question: Is this a case of the summer doldrums, or is there a breakout forming? Many traders believe that the longer a market consolidates in a narrow range, the larger and stronger the breakout will be.

Related Link: Stocks Clear First Half Above Water, But Challenges Haven't Changed

Since June 1, the August contract for NYMEX-listed West Texas Intermediate (WTI) crude oil futures has been locked between $57 and $62.25 a barrel.

"Many people are talking about a possible crude oil breakout, but implied volatility levels make the opposite case," says JJ Kinahan, chief strategist at TD Ameritrade.

"The implied volatility percentile is 28, at the low end of the range for the past 52 weeks," Kinahan notes. "Until we get some news that breaks us out of this range, we’ll see more of the same. For longer-term crude oil traders, this may draw buying interest at the lower end of the range and selling interest at the higher end of the range.”

"As volatility increases, there’s typically a better probability that we’ll break out of the range," Kinahan adds.

To gauge volatility, TD Ameritrade clients who use the thinkorswim® platform can use scripting on the Scan page and charts to monitor implied volatility (figure 1).

This article was originally posted here by Kira Brecht on June 23, 2015.

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