A reversal in optimism suggests higher energy stocks

Key points:

• The optimism index for the energy sector reversed higher relative to its recent range
• The energy ETF (XLE) has rallied 75% of the time over the next 2 months after other signals

Using the optimism index as a way to identify bullish sentiment reversals

A trading model that uses the Optix Index to identify when sentiment reverses from a period of pessimism issued a buy signal for the energy sector on 1/7/22. 

The model applies an 84-day range rank to the 10-day moving average of the Optimism Index for the XLE ETF. As a reminder, the range rank indicator measures the current value relative to all other values over a lookback period. 100 is the highest, and 0 is the lowest. The pessimistic reset condition is confirmed when the range rank for the Optix Index crosses below the 5th percentile. A new buy signal occurs when the range rank crosses back above the 78th percentile. At the same time, the 5-day rate of change for the XLE ETF must be >= 3%. i.e., market momentum is positive.

A trading model that identifies a reversal in the Optix Index

Energy stocks rallied 75% of the time after other signals

This signal has triggered 32 other times over the past 22 years. After the others, energy sector future returns, win rates, and risk/reward profiles were solid across all time frames, especially the 2-month window. The trading model performed well during the most recent energy bear market period between 2014-2020, with positive returns at some point up to 2 months later in 6 out of 7 instances.

Signals when the XLE ETF is trading above its 200-day moving average

This signal has triggered 18 other times over the past 22 years. After the others, energy sector future returns, win rates, and risk/reward profiles were solid across almost all time frames. Comparing the two signal types shows that the trend filter instances'  look slightly more favorable in the 1 & 2-month time frames across most metrics. The 200-day filter showed solid results in the 2003-8 energy bull cycle, with 9 out of 9 winners at some point up to 2 months later.

What the research tells us...

When the Optimism Index for the energy sector reverses from a pessimist level relative to its recent range, it signals that traders have become more optimistic about the future direction of energy stocks. Using the Optix index to measure that change in sentiment, similar setups to what we're seeing now have preceded rising energy sector prices, especially in the 2-month window.