'Gravity' Returns to the Oil Market
'Gravity' returns to the oil market... Crude suffers its longest losing streak in history… But this rare, once-in-a-decade extreme says a rebound is likely… Checking in on stocks…
When we last checked in on crude oil over summer, we noted a 'divergence' of sorts...
On the one hand, both fundamentals and sentiment were sending warning signs.
Despite ongoing production cuts from oil cartel OPEC, global oil production had actually been rising again. This was due almost entirely to a huge increase in U.S. shale oil production.
After plunging to less than 9 million barrels per day ("bpd") in early 2017, U.S. production had since rebounded to new all-time highs above 11 million bpd.
At the same time, oil had become one of the most popular assets on the planet. According to the U.S. government's weekly Commitments of Traders ("COT") report, "dumb money" speculative traders were more bullish than ever before.
History shows that these folks tend to be wrong at extremes... Whenever they all think prices will move one way, they almost always move the other direction. So this was also a signal that lower prices were likely.
And yet despite this bearish picture, oil prices continued to trend higher...
West Texas Intermediate ("WTI") crude oil – the U.S. benchmarks for prices – rose from the mid-$60 range at that time to more than $76 by the first week of October.
Then financial "gravity" suddenly returned.
Yesterday, WTI closed below $56, representing a 25% loss over the past five weeks. Through Tuesday, oil had fallen for 12 straight days, its longest losing streak in history.
This record-setting decline offers a timely reminder of the importance of risk management...
As folks who were leaning bearish on crude this year learned, trends can often go on longer than you might believe possible. In the short term, fundamentals can simply not "matter."
However, as bullish speculators also learned more recently, sooner or later fundamentals do matter... And when the market finally "wakes up" to reality, the reaction can be swift.
This is why we constantly urge you to use reasonable position sizing and trailing stop losses (or another defined exit strategy) on every investment or trade you make.
However, the crash in crude has also created a potential opportunity...
In this morning's edition of DailyWealth Trader, our colleagues Ben Morris and Drew McConnell noted the recent decline has created a rare setup that has led to huge rallies in the past...
The recent drop in oil is rare. And it has pushed oil into extremely oversold territory, as measured by the relative strength index – or "RSI"...
An RSI reading above 70 means an asset is overbought and may be due to slow down or pull back. And an RSI below 30 means the asset is oversold and may be ready to stabilize or rally.
As you can see in the chart below, just after hitting a new high, oil plummeted. Yesterday, it closed at its lowest level since December 2017. And its RSI fell to 13.4...
As they explained, we've only seen similar extremes three other times over the past 30 years...
That's just once a decade on average. And again, each has led to big rebounds in crude prices. They walked readers through all three of these examples to illustrate...
In the charts below, the blue arrows mark the first day oil's RSI crossed below 18. And we calculated returns based on that day (not necessarily the lows for the move). So let's look at the first time this happened...
In October 1997, oil traded for about $23 per barrel. Over the next four months, it fell down to $13.21 – a 42% drop. In the chart below, you can see that oil's RSI fell to 17.4 during that decline...
Oil put in a short-term low on the day its RSI closed below 18. Two weeks later, it traded 22% higher. Oil was volatile after that and did make lower lows. But the extremely low RSI reading led to a big, sharp rally.
The second came shortly after, near the end of that same year...
In late September 1998, oil traded for about $16 per barrel. Over the next six weeks, it fell to $11.13 (the blue arrow) – a 31% drop. Oil's RSI fell just below 18 on that move...
Oil fell a little lower after its RSI crossed below 18. But it bottomed soon after. Two weeks later, oil traded 3.8% higher. One month later, it traded 5.6% higher. And three months later, it traded about 51% higher.
Finally, the third followed that last great peak in oil prices a little more than six years ago...
In February 2012, oil traded for about $110 per barrel. Over approximately the next two months, it fell to $83 (the blue arrow) – a 24% drop. Oil's RSI fell to 16.3 during that decline...
In this instance, oil had further to fall. It dropped to $77.69, or another 6.7%, by June 28, 2012. But after bottoming, oil ripped higher...
Two months after its "sub-18" extreme, oil traded 7.9% higher. And three months later, it traded 10.4% higher.
Again, as we noted earlier, this extreme doesn't mean oil prices are guaranteed to rise from here...
And we never recommend basing investment decisions on any single indicator alone. But history suggests higher prices are likely in the near term. And at the very least, it's almost certainly a bad idea to bet on further downside in oil today. As Ben and Drew explained...
Hopefully, by now you can see that betting against oil after this rare extreme was a bad bet...
In nearly all cases, oil jumped higher shortly after its extreme RSI reading. And two to three months later, it was higher every time. So in the near term, we're much more interested in bullish trades...
But for new trades, we'd like to see at least some bullish price action before jumping in. We expect that to come soon... And as always, we'll let you know when it's time to place a trade.
For now, just be sure not to chase oil lower... at least not before a bounce. If you're bearish right now, history shows the odds are against you.
One last thing…
As you've likely seen, stocks declined again today.
Despite this week's pullback, the market remains above October's closing lows, as well the two critical "support" levels cited by our colleague Greg Diamond on Tuesday. This is a positive. If these levels can hold in the days ahead, we expect the recent rally will continue.
However, as we've warned in several recent Digests, we may not be "out of the woods" just yet. October's correction could still have further to run.
If last month's decline kept you up at night, it's a clear sign that you're taking too much risk. Please don't wait any longer. Raise some cash… Be sure to own some gold… And if you have a significant percentage of your portfolio in stocks, consider "hedging" with some short sales or long put options.
New 52-week highs (as of 11/13/18): O'Reilly Automotive (ORLY) and Procter & Gamble (PG).
A quiet day in the mailbag. Let us know how your portfolio is holding up at feedback@stansberryresearch.com.
Regards,
Justin Brill
Baltimore, Maryland
November 14, 2018