Technical Outlook: Don't Slip on Oil - TheStreet

Oil, oil, oil. That's about all you hear anymore when you read the financial papers, turn on the news or go out to dinner -- everyone is talking about investing in oil. The average investor walking down the street seems to be an expert, and is quoting the master T. Boone Pickens and his call for $150-a-barrel crude. I normally like to focus my columns on opportunities in the market, but protecting readers from a possible severe correction is also very important, and that's my goal today.

The situation with oil today reminds me of the story of the great investor Bernard M. Baruch back in the 1920s. One day while he was walking down Wall Street he decided to get his shoes shined. While he sat down and began to read the paper, the shoe-shine boy started giving him tips on stocks to buy in the market. Mr. Baruch proceeded to go straight back to his office and sold every holding in his portfolio. Soon after, the market begin to spiral downward.

This is not to say that what we're seeing now is going to lead to a mind-boggling correction. However, any time an industry, sector or stock gets extremely extended to the upside and everyone you know is talking about it, that may be time to take some profits off the table.

Oil and oil stocks have had a tremendous run, and over the long term they are likely to go much higher. However, once the hot money and momentum traders enter the market like they have in the oil service and drilling stocks, corrections can be sharp and severe.

One of the most glaring signs that the oil stocks are overextended to the upside is the fact that while oil was up almost $5 a barrel on Wednesday, the oil service and drilling stocks sold off hard. That usually tells me that the easy money has been made, and the institutions that move the markets are taking profits while individual investors are still buying.

Institutions like mutual funds and hedge funds need to take their profits while there is plenty of momentum and investors are overconfident about a certain sector. Once they have their profits and remove the buying support, you will see sharp spikes down in price. Those are situations that we want to avoid because they can quickly wipe out profits.

One of the sentiment indicators that I watch closely in the oil sector is the S&P Energy Sector Bullish Percent Index. This index measures how many stocks in the sector are in bullish patterns. You can see from the chart below that the index has closed over 90. That means over 90% of the stocks in the oil sector are in bullish patterns.

Now, that may sound like a positive thing to most investors and should be a signal that they should be buying energy shares. However, that's not how it usually works, because the chart cannot go above 100 and it rarely goes above 90.

In fact, when this chart reaches this area, it is a warning sign that investors have become too confident. That's normally a good time to take profits or to set protective sell stops under solid support levels on your stocks. Once the stocks have finished their correction, that is the time to go back in and buy solid companies at a discount.

Oil-Bullish

The

U.S. Oil Fund

(USO) - Get Report

is a domestic ETF designed to track the movements of light sweet crude oil. You can see from the chart below that the green line that represents the price is up almost 22% above its normal trend. When you have a stock or sector that becomes this extended from the normal price movement, it normally suggests that the momentum traders are in control. That is great when the stock is going up, but when they start to take profits and head for the exits, look out!

It would probably be a lot less risky to start or add to positions after the price drops back down to the yellow trend-line. However, you don't want to get too carried away at first in case the price slices straight down through it. It is better to start off with a small position and add to it when you see that the uptrend remains intact.

Most oil-and-gas drilling and exploration companies are also well extended from their normal bases. You can see that from the chart below that this index is more than 24% above the normal three-year up-trend. In most cases, that is certainly not a good time to buy and it is usually a reasonable time to take some profits off the table.

I've been talking positively about the commodity and oil stocks on the

Real Money

Web site for several years now. However, there are times when every industry gets ahead of itself from our price standpoint. When that happens, it normally means we are close to a time of correction.

Much of this also depends on supply and demand of oil. Currently, demand is aggressively outstripping supply. You also hear many commentators talking about a bubble in this area of the market. I personally think that is ridiculous because these stocks are trading at very low price-to-earnings ratios compared with their growth. However from a short to intermediate-term perspective I believe the hot money has pushed these markets too fast and too far in a short period of time.

At time of publication, Manning had no positions in securities mentioned, although holdings can change at any time.

Mark Manning, AAMS, is an Accredited Asset Management Specialist and Registered Investment Advisor with Butler, Wick & Co., where he specializes in wealth management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Manning appreciates your feedback;

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