May 7th, 2008

Momentum in Oil & Gas Stocks and the Risk of Compacency

There’s never been a better time for momentum investing. I don’t know how this is going to end or when but for now, the stocks that had gone up before are the stocks that are going up now. And those stocks are oil & gas.

Alright, I’ll grant you that there are fundamental causes and explanations for them to move up – everyone has already heard that oil hit $122/barrel, a new all-time high. The situation was further fueled (no pun intended) by a report this morning from Goldman Sachs that “the price of oil could shoot up to $200 a barrel within the next two years as part of a ‘super-spike’ driven by poor growth in oil supplies.”

To a true momentum payer, none of the background noise matters. The only thing that really does matter to that sort of trader is that the stocks that moved up the most last year are turning out to be the stocks that are moving the most now.

I included the following table in this past weekend‘s posting about the group:

The key point was that 32% of the top 100 IBD stocks were Oil&Gas and other Energy stocks. If you’d bought any of those stocks (or almost any of the 438 other stocks IBD categorizes as Oil & Gas) then you would have seen a gain today. Actually, 36 of 115 stocks in the Oil&Gas-US Exploration and Production Industry Group hit new highs today.

The point is not to beat to death today’s gainers (or the sorry state of this country’s mock effort at “energy independence”) but to impress on you the merits and importance of momentum investing. I’ve been doing quite a bit of research on the subject for my book and am amazed at the extensive effort exerted by academicians to debunk what they consider to be no more than “reading tarot cards”. My favorite quote is:

“A profitable momentum strategy is inconsistent with the existence of rational investors and an efficient market [my emphasis added]. Any success from momentum investing is just as plausibly due to luck, or the possibility that the momentum style inadvertently exploits investment drivers that do matter, or the ability to find a temporary anomaly in the stock market – but none of these proves that investors will pay a premium for momentum. The burden of proof is on the momentum investors to show that momentum pays.” (Applied Mergers and Acquisitions by Robert F. Bruner, Contributor Joseph R. Perella, John Wiley and Sons, 2004)

Tell that to all those who made tons of money (to help them pay for the higher tab they have to pay to fill up their cars at the gas pump) by getting into oil&gas stocks (see my March 7, 2007 post).

Momentum does work and the thrill is finding the next group or stock with momentum. That’s sort of the easy part. The hard part is knowing when to get out because when the “herd” abandons a stock or group it does so quickly, with everyone running for the exits almost at once.

So even as we savor the our oil & gas profits, it simultaneously feels eerily disconcerting and reminiscent of the tech bubble era as Goldman Sachs comes out with a report calling for a spike of $200/barrel oil. (remember the predictions of a 40,000 DJIA just as the tech bubble was about to burst?)

Does that actually mean that Goldman Sachs is priming the pump to build demand for the oil & gas stocks so they have more willing buyers for the shares they’re dumping? Conspiracy theory perhaps but it does bring to mind one of the trading quotes I mentioned just yesterday:

“While enthusiasm may be necessary for great accomplishment elsewhere, in Wall Street, it almost invariably leads to disaster.”-Benjamin Graham

So let’s be excited but be on the alert for complacency.

Subscribe below or click here to learn more about help for navigating turbulent markets.