Should we buy the oversold condition in energy stocks

Key points:

• The percentage of oversold stocks within the energy sector exceeded 95% 
• After similar conditions, the energy sector was higher 71% of the time three months later
• When most energy stocks are in long-term uptrends, the industry is higher every time

Energy stocks plunged, triggering a historic oversold condition

In a recent note, I shared a study suggesting energy stocks could decline in the near term as the sector diverged from crude oil. Two weeks later, the group was down 10%. 

The swift correction created a potentially bullish setup for the sector, as most stocks maintain a rising 200-day average. In uptrends, I want to be a buyer of oversold conditions. Rinse and repeat. 

For only the 23rd time since 1953, the percentage of oversold stocks within the S&P 500 energy sector exceeded 95%. An oversold condition occurs when the 14-day stochastic oscillator, a momentum indicator, falls below 20%.

Similar oversold conditions preceded bullish medium-term results 

When the percentage of oversold S&P 500 energy stocks exceeds 95%, the sector tends to bounce, especially three months later. The signal struggled during unfavorable long-term trend conditions for the group, which is not the case now. With two out of three recent alerts registering a lower low, a short-term trend filter would make sense from a trade timing perspective.

A bullish long-term trend backdrop

The long-term trend backdrop for S&P 500 energy stocks remains favorable, with over 95% of sector members maintaining a rising 200-day average. 

The current trend profile looks similar to other bullish secular periods like 2003-08 and 1974-80.  

Suppose I include a filter to the original study, which requires more than 90% of S&P 500 energy sector stocks to have a rising 200-day average. In that case, the oversold condition within the context of bullish long-term trends for energy stocks suggests we should buy the dip.

What if a recession occurs in 2023

While it could always be different this time, the energy sector typically provides positive returns in the first few months after the NBER declares a recession. And from a sub-sector perspective, integrated oil companies tend to perform the best.

What the research tells us...

Secular bull markets in energy stocks are rare. And, even when they occur, trading the daily gyrations can be challenging. For only the 23rd time since 1953, over 95% of S&P 500 energy sector stocks registered an oversold condition based on the 14-day stochastic oscillator. After similar precedents, the energy sector tended to rally on a medium-term basis. When an oversold condition occurs within the context of a favorable long-term trend profile for individual energy stocks, the outlook for the sector is bright.