I’ve been anticipating a bottom on energy stocks for all of 2017. And now that it’s come and gone I want to take a minute and extract all of the lessons left in its wake. For newcomers to the charting space, the behavior in XOP (my go-to ETF for trading energy) provides a perfect case study for learning how stock prices bottom. The transition from downtrend to uptrend was virtually textbook.
The first sign that a bottom is looming is often slowing momentum. This signal strikes when a downtrending stock forms a lower pivot low but with decidedly less oomph than its predecessors. Sellers are still in control, but it’s as if their hearts just aren’t in it anymore.
Perhaps the easiest way to illustrate this is looking at the channel that formed in XOP from January through August. Notice how the previous downswings (labeled 1 & 2) carried XOP all the way to the lower trendline. But the final one (3) didn’t come anywhere close. So although the energy ETF formed a lower pivot low in August (yellow lines), the momentum was waning.
Of course, to reach its full potential and deliver a bona fide trend reversal, slowing momentum must be followed by a resistance busting rally. Breaking the upper trendline and the 50-day moving average marks progress, but what is really needed is the formation of a higher pivot high which results when the stock breaches a horizontal resistance level.
You’ll note the September surge cleared the 50-day and the upper end of the channel (purple circle). But it was the vaulting above resistance at $33 that sealed the deal (yellow circle).
Following the September rally, XOP had become quite overbought suggesting a pullback was in the cards. Watching closely during such an episode is crucial because the depth of the dip reveals whether or not bulls stepped up to defend their newfound foothold. Think about it this way – XOP bottomed at $29 before its trend-reversing run up to $34.50. How much giveback is okay before the new uptrend is threatened? The answer is about 1/3 to 2/3 of the prior advance. In Fibonacci-speak we say 38.2% to 61.8%. Any more than that and you really start to question the sustainability of the recent breakout. We certainly wouldn’t have wanted to see XOP fall all the way back to $29 or $30.
So how far did XOP retreat? Take a look:
Right into the sweet spot, baby! And the fact that it kissed the 50-day moving average was a bonus. Elliot Wave theory comes into play here as well. Now, hold the rotten tomatoes and cabbage for a sec! I rarely if ever bring up this convoluted art of analyzing prices, but it explains the bottom in XOP perfectly. And, besides, I had to memorize all sorts of interesting principles about Elliot Wave back in the days of my CMT exams, so I suppose I owe it to my former self to at least bring it up a time or two.
Here’s the principle:
Wave two in the five way impulse sequence is not supposed to retrace all of wave one.
If it does, then it wasn’t wave two! So recount, ya dummy! Here’s the XOP bottom with wave counts:
If you’ve had the immense pleasure of viewing our Technical Analysis 101 video series, then you know that indicators like volume, RSI, MACD, and the like are secondary to price. The bottom in XOP is a wonderful example of volume confirming the bullish price action.
Note how volume soared during wave one and was followed up by yet more participation during wave three. What’s more, volume was very subdued during wave two showing a lack of motivation by sellers.
The recent episode in XOP is perhaps my favorite example in recent memory of how a stock should bottom. Technical analysis doesn’t always work out perfectly, but when it does, it’s a beautiful thing.