OSX 2005 vs SOX 2000

I’ve been neutral to outright bearish on the oil stocks for almost six months now but a recent piece of research that suggests the OSX is due for a blow-off top has me rethinking my negative stance.   

I’ve been bearish because 1) sentiment was becoming over-exuberant about the prospects for higher oil prices ($100 oil target by Goldman Sachs); 2) rising stock prices have discounted much of the increase in the commodity, already (the OSX and Energy Sectors are by far the strongest industry groups for the past year); 3) despite the concerns about "peak oil," the oil and natural gas inventories are actually above 5 year averages; and 4) price has been overextended numerous times and the DeMark indicators have given numerous sell signals. 

The recent drop in the price of oil vs the corresponding rise in oil related stocks had me becoming even more bearish.  It seemed to me that the market had completely lost touch with the underlying commodity price and was trading solely on momentum. 

However, a piece from Tycoon Research has me revisiting my bearish thesis.  It’s a simple argument – the OSX is about to experience a blow-off move like the SOX did in 1999.  From hedge fund manager Teeka Tiwari comes the following analysis…

I’m buying options on the Philadelphia Oil Service Index, or OSX for short. As I’m sure many of you know, Oil Service stocks are the companies that provide all of the ancillary services 
to the major oil companies. They provide drilling rigs, helicopters, seismic surveys, well construction, etc …

The Big Oil companies are currently sitting on over $100 billion in cash, and must put it to work or risk having Congress take it away from them. Don’t think Congress can’t impose "windfall" taxes and price controls.  They did it in the ’70’s, and aren’t above making the same mistake twice if the political heat gets intense enough. 

Because of fear of collapsing oil prices, Big Oil companies have vastly UNDER INVESTED in finding and bringing on line new oil wells; but find more oil they must, or risk the wrath of Congress. 

It’s this massive pent up exploration spending that is going to drive the oil service stocks through the roof. 

Think about it logically. The OSX is trading at about the same level it was when it peaked back in 1997 and 2000.  Anyone remember what oil was trading for in 1997 and 2000? It was $26 and $36.50 respectively!  That’s a heck of a lot less than today’s price of 58 bucks.

That’s a pretty straight forward argument and the charts and fundamentals back up the idea.  The following is a weekly chart of the SOX from 1995 to the latter half of 1999.  In 1999, the SOX had already made a strong move out of a four year base and had blown past several DeMark sell signals, as the chart below shows.

Source: Bloomberg

Similarly, the OSX has already made a strong move out of a multi-year base blowing past its share of DeMark sell signals, too.

Even after a strong run, the SOX managed to stage a huge blow-off into 2000.  After moving steadily higher in the latter part of 1999, the SOX formed a small base and exploded higher in 2000 until it hit the top of the tech bubble in March 2000. 

The key to staying long in a momentum trade like this is having the patience to ride out the volatile sideways consolidations.  As long as the market doesn’t make a lower low, the potential for a blow off run exists.  The two charts below show the consolidation areas marked in green boxes.

Besides being an anagram (eerie!?!), the OSX and SOX industry dynamics are actually remarkably similar.  Both are highly cyclical industries.  Both industries experience wild swings in earnings because of the high fixed costs and cyclicality of the business.  Both industries often trade on "peak earnings" (what the companies will earn at the top of the cycle) multiples.  And both industries are subject to wild swings in the stock prices because investors often times confuse the rising cycle with a "new era of growth".

And, like the OSX, the SOX looked expensive when it started its move higher but only became more expensive as the blow off progressed.  The SOX started its run when the industry traded around 40x earnings and didn’t peak until it traded at well over 70x earnings, as the chart below shows.

Source: Baseline

Similarly, the OSX currently trades around 32x earnings, which is still at the low end of the historical range.  If the market becomes over exuberant, I could easily see the OSX trading at 50x – 70x earnings. 

So while I hesitate to buy stocks high in hopes of selling them higher, I also realize that I have been wrong about energy stocks in the past six months because I didn’t "see" the other side of the trade.  A blow-off top is a very valid scenario that makes me more reluctant to be short the stocks and even contemplating switching to a long posture.