Energy stocks reverse higher after a historic oversold condition

Key points:

• The percentage of energy stocks above their 10-day average exceeded 95%
• The surge in uptrends occurred after 95% of energy stocks reached an oversold level
• After similar conditions, the energy sector was higher 79% of the time one month later
• When most energy stocks are in long-term uptrends, the outlook is even better

Energy stocks are surging from a historic oversold condition

If you like trading high-volatility stocks, the energy sector is ripe with opportunity. Last week, I published a note highlighting the extreme oversold condition in energy stocks. The slide in the energy group didn't last long, as more than 95% of the members within the sector recaptured their 10-day average. 

Let's assess the outlook for the energy sector when more than 95% of energy stocks exceed their 10-day average in ten days or fewer of an oversold condition. The oversold condition occurs when more than 80% of energy sector members register a 14-day stochastic oscillator reading of less than 20%. 

Similar oversold to overbought reversals preceded bullish results

When the percentage of S&P 500 energy stocks above their 10-day average exceeds 95% in 10 days or fewer of an oversold condition, the sector tends to rally, especially one month later. The signal was positive two months later in 28 out of 33 cases. Noteworthy drawdowns all occurred during significant bear market periods. 

Suppose I include a condition to the original study that requires more than 75% of energy sector members to have a rising 200-day average. In that case, a surge in short-term uptrends from an oversold condition bodes well for energy stocks. The signal in 2011 is the exception, not the norm.

What the research tells us...

Whether a short-term trader or a long-term buy-and-hold investor, the energy sector has been the place to be this year. Typically, buy-the-dip strategies struggle in bear markets, but that's not the case for energy. The industry provided several alpha-adding opportunities this year. And we just got one more. When the percentage of S&P 500 energy stocks above their 10-day average exceeds 95% in 10 days or fewer of an oversold condition, sector performance is impressive, especially one month later.