Fear and greed in the energy sector have reached a fever pitch in recent weeks. While analysts struggle to devise new methods of fundamental analysis to predict the oil price, technical analysis – as a means to measure investor sentiment at every oil price – is taking center stage.
Relative Strength Index, my favoured tool for technical analysis, has an excellent track record for identifying lucrative entry points for investments. The simplicity of the RSI calculation belies its effectiveness. Using specific time periods, usually 14 trading days, RSI compares the average percentage gain for an asset on up days to the average percentage loss on down days.
RSI produces a number between zero and 100. Historically, a reading below 30 is a buy signal suggesting an asset is oversold and due for a bounce. An RSI above 70 means the investment is overbought, technically extended and due for a correction.
This week's chart shows that according to RSI, West Texas Intermediate crude oil has been deeply oversold for longer than at any point since the height of the global financial crisis. Market history suggests the oil price is due for a significant bounce higher.
RSI's track record for identifying market bottoms for the oil price is encouraging. In January 2007, for instance, an oversold reading of 23 – close to the current level of 22 – signalled a rally that would take the WTI price from $51 (U.S.) a barrel to over $90 in the following 12 months, despite the intensifying financial crisis. More recently, an RSI oversold reading below 20 in June of 2012 marked the beginning of a 40 per cent rally in the oil price.
Of course, past market patterns are no guarantee of future results. But it's also true that technical analysis takes on added significance when volatility surges, fundamentals are thrown out the window, and emotions dominate trading and investment decisions.
Technical analysis, which is at base a series of methods to quantify sentiment, can be a far better means of finding short term market tops and bottoms than valuation levels. This is particularly true at present in cases like energy stocks where trailing price-to-earnings ratios, for instance, are a poor guide to future profits, because the commodity price environment has changed so dramatically.
Our chart suggests that the panic in energy markets has more or less run its course. There is clearly a lot to worry about in the energy space but the technical picture looks like the depths of the financial crisis, when the entire global economy froze and the solvency of almost every global bank was in question. The situation is hardly as dire now, which is another reason it's probably safe to start looking for bargains in the energy sector.
Follow Scott Barlow on Twitter @SBarlow_ROB.