Now is not the time to put more money in oil stocks

By Jason Chow
Globe Investor Magazine Online, May 23, 2008

The sharp moves of oil stocks on Canadian stock markets this week had the hearts of market watchers up at their throats.

Wednesday, in particular, was a bad day. Not only did the S&P/TSX composite index slip 1.7 per cent, the energy sector - the main cause of the Canadian stock rally of the last two months - slid 1.5 per cent while the price of oil actually rose to new highs. This is a bad sign, say the technical observers.

As investors contemplate adding more money to what seemed like an endless rally, market experts are waving the caution flag, while others are firmly showing the checkered one, arguing that this phase of the speedy rally is over.

"Oil was up, but the sector went down. It could be a signal," said Jeff Parent, portfolio manager at Quadrexx Asset Management in Toronto on Wednesday. "I do have to wait for confirmation but this could be the end of the big rally. This may be the turning point." For him, this technical confirmation would mean a sharp 5- to 10-per-cent drop in the S&P/TSX capped energy index within a week.

The major rally in Canadian markets this year has been largely fuelled by the oil sector. The energy index has risen 52 per cent from its mid-January lows to its high on Tuesday and those who have followed the oil-loving herd have made huge gains. The oil sector is still a great place to invest over the long term, they say, but you should wait before you pile more money in. So when exactly is a good time to buy again?

Larry Berman, chief investment officer at ETF Capital Management in Toronto, watches the iShares S&P/TSX capped energy index ETF (XEG/TSX), which directly tracks the energy index. He still believes that oil stocks are in long-term bullish trend, but the time to get back in would be to see the index dip 10 per cent. The ETF is trading at $113, and he says investors should watch it go back down to the $100 range before buying again.

"From a risk-reward perspective, I'd like to see the sector closer to $100 to get in," he said. "It's probably prudent to buy some at $110 already," he said, adding that these kinds of pullbacks "have proven to be short-lived."

Colin Cieszynski, market analyst at CMC Markets in Toronto, agrees that there's a short-term reversal that could be very sharp in the near term. Wednesday and Thursday's market action were, to him, "key reversal days" - a new high followed by a significant sell-off. On Wednesday, oil stocks had their key reversal day, hitting historic highs before falling sharply. Then on Thursday, the commodity price for crude oil did the same thing.

"This can suggest that we're in for a period of consolidation and correction," he said.

For him, there are two things to look for that may signify the beginning of a new bull phase. First, he's looking for a divergence between the large-cap oil stocks and the price of crude. The commodity prices often lag the prices of the stocks, he says. On Wednesday, he points out, the stocks fell while the price of crude rose, and the following day, the price of crude fell as well. When the opposite happens (stock prices rise while oil prices fall), it could be a signal of another bull phase.

"Wednesday was the divergence - oil prices up, stock prices down," he said. "Keep an eye out for the reverse of that."

The other sign he's watching is the support level - the point where it is perceived that there are more buyers than sellers - of the energy index. He points out that the energy index was in the 300-380-point range for most of last year. When the index finally broke out, he set a target price of 460 (the target is derived by adding the width of the range - 80 points - to the top of the previous range). The 460-point target was reached earlier this week. Now, he says the support level for the index is currently at 440. If the index falls but fails to break below this level, then it could be a time to buy. If it goes below 440, wait it out until the next support level at 415.

"The short-term trend is over for now," he says. And that means investors will have to be patient until the next bull comes around.

Special to The Globe and Mail