Oil Stocks: Are Investors Headed Into a Bull Trap?

The rally in stocks with exposure to oil and china may be overdone

Performance in the major stock indices has been strong since Sept. 30. The strongest-performing group has been oil stocks (and related industrial firms), which can have an outsized impact on the major averages.

Oil Stocks: Are Investors Headed Into a Bull Trap?At the same time, Chinese banks and markets have been closed for the National Day holidays, which end Oct. 8. Is there a connection between the two factors?

Despite good news in the sector, the question is whether the fundamentals of commodity demand has really changed. The answer to that is both yes and no … mostly no.

The recent news feed is actually a good illustration of our concerns. Last week’s rig counts were down (which is a small change in favor of higher prices) and probably triggered the rally in the first place. Yesterday’s international inventory numbers were also down a little, which also caused a bullish reaction in the market.

However, all bets seemed to flip on a dime with Wednesday’s rising oil-inventory data from the U.S. Energy Information Administration. The major indices (and oil stocks) turned lower at the exact moment the inventory report hit the news.

News-driven trading like this is created by “hot money” that is prone to jump in and then back out of the market very quickly. Inventory numbers have not been shown to be correlated to stock/oil price movement beyond the day they are initially released. The bottom line is that long-term changes in the oil market must be driven by a shift in the fundamentals; which, these days, means Chinese growth.

Today’s report from Yum! Brands (YUM) is an exemplary case in point. While we have waited over the last week to receive new Chinese economic data, YUM reported earnings that missed expectations, citing a lack of growth in China. The stock dropped 19% on the news and is likely to see further losses. While we can draw some inferences about oil prices and China from YUM, as well as other stocks with Chinese exposure, the technical picture for oil makes an even stronger argument for a bull trap.

As you can see in the next chart, the price of West Texas Intermediate oil futures has reached its highs from the short squeeze in August. A break higher could be driven by improving fundamentals, but the case for that continues to look weak.

On the bright side, though traders (including us) have struggled through the whipsaw, there may be some attractive opportunities for bearish trades in stocks that have experienced a short squeeze of their own over the last week — especially if oil breaks support at $44.

WTI Crude Oil Futures: Chart Source -- TradingView.com

WTI Crude Oil Futures: Chart — TradingView.com

The stock market, oil prices and investor sentiment in general, are on an edge that could tip lower fairly easily. It’s a little too soon to call a short-term top, but this is the exact price level at which we would have expected to see a top appear if the market rallied.

For now, we recommend preparing for potential bearish trades to leverage the unreasonable rallies in stocks with exposure to oil and China, such as Caterpillar (CAT), Exxon Mobil (XOM) and YUM! Brands.

(You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.)

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/10/commodity-oil-stocks-china/.

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