When This Sector Was Underrated, Our Tools Knew Better

By TradeSmith Editorial Staff

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When the markets speak, do you listen?

In late 2020 and early 2021, while lockdowns remained in full force and uncertainty gripped the globe, our platform caught wind of something unusual brewing…

A resurgence in energy stocks.

Today I’ll dig into how and why TradeSmith Finance identified one of the greatest trades that almost no one saw coming.

After oil went negative (yes, negative) in spring 2020, not many believed the sector could ever recover.

Markets always send messages, but translating them isn’t always easy.

Like an organism, the tale of the tape is woven by billions of small parts.

TradeSmith Finance can decipher coded market messages the human eye can easily miss.

Here’s how that created one of the most incredible finds in recent history.

Health Matters

If someone tells you a market is “healthy,” what does that mean to you?

Is it a matter of stocks trading normally, or simply not being in a free fall?

While our algorithm is proprietary, its general thrust is to identify changes in the underlying conditions around a stock or market.

For everyday traders, this can be as simple as looking at when the 50-day moving average closes above the 200-day moving average.

We keep it simple with health zones of green, yellow, and red.

Let’s take a look at the energy ETF, XLE.

Source: TradeSmith

Across the bottom, you can see the color-coded indicator that identifies market health.

In mid-2019, XLE oscillated between green and yellow health before sliding into red.

Simply put, the price trend kept bleeding lower.

This didn’t change when everything crashed in 2020.

It wasn’t until March 2021 that our Health Indicator for the ETF suddenly flipped from red to green.

However, there were clues underneath the surface.

We pulled some historical data from our TradeStops system, looking at energy stocks that received a “buy” signal in 2020 and 2021.

Of the 75 stocks that we pulled, 73.3% of the buy signals occurred in Q4 of 2020 and Q1 of 2021, with 34.7% of signals occurring in November and December.

That’s a heck of a turnaround, considering that oil traded in negative territory just a few months earlier.

And it also preceded the comeback of the broader XLE ETF by several months.

In fact, XOP, the ETF that tracks oil and gas drillers and is more sensitive to oil prices, flipped from red to green health one month earlier than the XLE.

In contrast, a majority of the stock sectors flipped from green to red during that same time frame. Yet it’s fair to say that most of them lacked the enormous headwinds of the energy complex.

In fact, few of them expected to see positive operating cash flows in the next several quarters.

Now check out how the top 10 symbols in energy have done since then.

Source: TradeSmith

What Creates a Great Trade

Not every healthy sector is primed for screaming gains.

If you think I’d jump into a stock or ETF without a clear signal, think again.

I learned over the years that investing and trading is a combination of the qualitative and the quantitative.

We need to marry the story with price action.

Funny enough, while few and far between, there were articles out in the blogosphere in late 2020 that forecasted a rise in crude oil and natural gas due to an imbalance in forecasted supply and demand along with dropping inventory levels.

Unfortunately, the actual commodities didn’t really move until later in 2021.

However, if you watched the energy stocks, you’d have seen them rise and hold their gains well ahead of the broader movement.

This same pairing of an investing idea and price action is exactly why our indicators went yellow on the Nasdaq 100 in January and red in February this year.

At the time, technology finished out 2021 after an incredible run. Yet the threat of higher interest rates forced investors to reconsider growth stocks in favor of value.

That’s precisely why XLP, the ETF that measures consumer staples, maintained green health with only a short stint of yellow health in March of this year.

As many finance books teach, investors seek the safety of low-volatility value stocks like consumer staples in times of uncertainty, shying away from growth companies like those in the technology sector.

Now, I can’t sit here and tell you that every idea you pair with technicals will be a blowout. Nor will every one even be profitable.

What I am saying is that pairing technicals with your investing thesis increases the odds and magnitude of your potential success.

And I’ll let you in on a little secret: I like to have multiple sources that are completely unrelated confirm an idea. Matching up qualitative and quantitative evidence is one way to do this.

Another method is checking out uncorrelated strategies like our Low Risk Runners or even following the trades of investment whales.

Don’t forget alternative investments, either. I’m talking about cryptocurrencies, options, forex, and a host of other markets most of us only touch on the periphery.

You don’t have to be active in these markets to run a screener every so often to look for ideas.

Looking into the next year, which undervalued or oversold sector do you believe is due for a bull run, and, more importantly, why?

Email me your analysis and lay out your case.