Is Energy Ready For A "Dead Cat" Bounce?

Each week in my weekly newsletter I do a complete overview on major markets, sectors and other market areas such as interest rates, gold and oil. I bring this up because the recent melt-down in oil and energy related stocks is something that I warned about in early August of this year when I wrote:

"Analysis: Massive Divergence Not Healthy

While oil prices have surged this year on the back of geopolitical concerns, the performance of energy stocks has far outpaced the underlying commodity.

The deviation between energy and the price of oil is at very dangerous levels.  Valuations in this sector are also grossly extended from long term norms.

If oil prices break below the consolidation channel OR a more severe correction in the markets occurs, the overweighting of energy in portfolios could lead to excessive capital destruction.

While the argument has been primarily focused on the "yield chase," the "price destruction" will far outweigh the desire for income. It is a good time to take profits in the sector and reweight portfolios back to target goals."

During the entire reversion process, I kept warning in that weekly missive that things would get worse for both the commodity and the energy sector as the supply/demand imbalance grew and deflationary pressures circled the globe. Those predictions have come to a rather painful realization.

The good news, as I will address in more detail in this weekend's X-Factor Report, is that the selloff in oil has gotten to extreme levels. This decline should allow for oil prices to experience a rather significant "dead cat" bounce. This is shown in the chart below, where previous plunges to current extremes have resulted in a rather significant bounces back to at least the previous trendline break. (I have used performance to keep the scale in proper alignment),

(In this weekend's analysis I will get much deeper into the technical analysis of standard deviations and moving average divergences.)

However, instead of oil moving back into a longer term "bullish" uptrend, I am becoming much more pessimistic about oil in the near term. As I addressed recently, the supply/demand imbalance is growing rapidly as production is rising and demand, due to global recessionary forces, is declining.

"First, the development of the “shale oil” production over the last five years has caused oil inventories to surge at a time when demand for petroleum products is on the decline as shown below."

"The obvious ramification of this is a 'supply glut' which leads to a collapse in oil prices. The collapse in prices leads to production “shut-ins,” loss of revenue, employee reductions, and many other negative economic consequences for a city dependent on the production of oil."

For now, any bounce in oil prices, and subsequently a bounce in related energy positions, should be used as an opportunity to underweight this sector in portfolios until the bullish trends reassert themselves at some point in the future.

Hold Up On That Keystone Pipeline For Now

I have been a big proponent of getting the Keystone Pipeline approved to transport oil from Canada to the U.S. more cheaply, safely and effectively than the current railcar method currently utilized. The construction of the pipeline will create jobs, and lower prices that will be a benefit to consumers.

This morning, a WSJ op-ed was released detailing the newly controlling Republican's plans to move the country forward. The Keystone pipeline was specifically addressed therein. To wit:

"These bills include measures authorizing the construction of the Keystone XL pipeline, which will mean lower energy costs for families and more jobs for American workers."

Here is the problem of approving the pipeline now. With oil prices already under pressure from a rising supply glut, as discussed above, an additional inflow of product will only act as a further drag on oil prices. With oil prices already at levels where drilling in more exploratory manners is no longer cost efficient, a further sustained decline in oil prices could have an adverse effect on the economy as profits decline, investment is reduced and jobs decline.

A more effective use of Republican efforts would be to reduce the regulations surrounding the building of refineries and export terminals for the existing supply build and specifically liquified natural gas (LNG.)  Such efforts would begin to reduce some of the excess supply, create jobs and stimulate economic activity. However, even those efforts may have limited effect as global demand for exported oil is dropping as global deflationary pressures increase.

In my view, while approving the Keystone pipeline now would be chalked up as a"victory" for the Republican controlled Congress, in the longer term it may wind up having an adverse effect that winds up "biting them in the ***."

Is This A Sucker's Rally

Michael Sincere wrote an interesting piece this morning for MarketWatch stating:

"After last week’s remarkable U.S. stock market rally, a lot of investors are cheering. After all, the Dow made an all-time high, won back the lost 1,000 points, and ignored the 8% pullback. I hate to be a party-pooper, but this is not a time to celebrate, but rather to be cautious."

He goes on to make six (6) points to support his case for caution:

1) Fewer stocks were making up the rally. Visa made up 123 points of the 221-point rally on Oct. 30th.

2) BOJ stimulus surprise jolted markets, but stimulus hasn't worked in Japan.

3) Indicators suggest that there was little institutional support behind the recent rally.

4) Volume has been declining during the recent rally.

5) Market breadth, volume and institutional support has been weak.

6) Leadership in transports has been narrow.

Michael is correct about the deterioration of the technical underpinnings of the market. The market is a biological organism made up of the all the individuals participants that are executing transactions each and every day. These technical measures are a "real-time" diagnosis of the "health" of that organism, and when those internal measures break-down it is a symptom of a broader illness.

Not paying attention to the symptoms, failing to diagnose the problem and not taking any defensive actions will ensure that investors fall victim to the full-blown effect of the illness. Even minor colds can have a lasting impacting on portfolio performance over time, and as I have discussed previously, making up previous losses has never been a prescription for long-term financial health.

Is this a "suckers rally?" Maybe, but only time will tell. However, taking some action in portfolios to reduce risks, take some profits, and rebalance your allocation model is always a great way to prevent coming down with a "cold."