The energy sector advance-decline line breaks out to a new high

Key points:

• The advance-decline line for the S&P 500 Energy sector closed at a new multi-year high
• At the same time, the S&P 500 Energy sector resides below its high, creating a bullish divergence
• Similar disparities between the AD line and the index produced bullish outcomes for energy stocks

The granddaddy of market breadth indicators suggests a breakout in the energy sector

Last week, I highlighted a breadth thrust signal for the S&P 500 energy sector, suggesting that the group's bullish price action could persist over the ensuing month. Following a pause on Monday, the group catapulted to a fresh year-to-date high on Tuesday, propelling numerous market breadth indicators to new heights.

One of the indicators, the advance-decline line, concluded the session at a new multi-year high, marking a bullish divergence as the energy sector remains below its previous high. Usually, stocks enter a catch-up phase when the advance-decline line reaches a new high before a stock index.

I applied a two-year range rank to both series to capture a divergence between the advance-decline line and the energy sector. The chart below shows that the AD line closed in the 100th percentile, indicating a two-year high. In contrast, the two-year range rank for the energy sector closed in the 92nd percentile, reflecting an index level below its two-year high but not far off.

Similar divergences between the AD line and the index preceded positive returns 

In instances where the S&P 500 energy sector advance-decline line reaches a two-year high, as the index ranks between the 90th and 99th percentile of its two-year range, the S&P 500 energy sector tends to rally over the subsequent year, with returns and win rates exceeding the study period results across every one of the outlook time frames.

In 24 of the 28 instances, the index surged to a new 2-year high before six months had passed, with the majority of occurrences happening swiftly thereafter. Please see the exit type column for new high precedents.

In just two instances over the following two months, the maximum loss exceeded -10%, a remarkable anomaly given the sector's typically volatile nature. 

Absolute and relative trends

While absolute and relative trend scores for energy ETFs remain uninspiring, both are improving, especially relative trends, with the equal-weighted energy sector jumping seven points over five sessions. 

Since my breadth thrust report last week, absolute trend scores for the energy sector stocks have improved, while relative scores have held fairly steady. 

What the research tells us...

The energy sector continues to fly under the radar, showing improvement from price and participation-based measures. The latest indicator to highlight this improvement is the grandaddy of market breadth indicators, the advance-decline line. With the AD line closing at a new multi-year high, the energy sector may soon narrow the gap if history rhymes. While absolute and relative trends for sector ETFs are improving, and some energy stocks look compelling, an underweight allocation is advisable. i.e., the sector remains a rent versus a buy-and-hold group.