Can Energy, Ag Continue To Surge?

Energy and agricultural issues have moved sharply higher since the January lows, outperforming other market groups by a wide margin. They continued to shine when the major indices pressed up to two-month highs ahead of last Friday's reversal and have held up well since, with several components posting new rally highs.

But can these leadership stocks buck the tide if the broad market heads back to the winter lows, or will gravity finally take over and kill the last strong stocks left standing in this wicked environment? Let's look at evidence on both sides of this critical argument.


Energy
Crude oil is trading over $100, and natural gas continues to grind higher in its strongest run in many years. This bullish backdrop provides support to the entire energy complex and should continue to do so through the summer. Nat gas is especially interesting because it is now sitting above $10, which has been a major barrier for the last eight years.


But it isn't a slam-dunk that energy stocks will move in lock step with their underlying commodities. Historical data predict that these issues will follow the futures markets in quiet times but track the equity indices in wild times. This occurs because macro forces affecting the broad stock universe can affect sector profitability despite a booming oil market.

With this two-sided relationship, I look for energy stocks to gravitate toward index leadership whenever the Market Volatility Index rises above 25. This indicator closed at 23.82 in Monday's session after ticking higher for the last two days. So it's nearing the critical level where equities might decouple with the futures markets.

However, energy stocks should fall at a slower rate than other equities if the broad market heads back to the 2008 lows. The cushion of higher oil prices won't disappear just because stiff headwinds are battering other types of stocks. So these issues should retain their major status in investment portfolios, while market-timers look to protect profits.


Agriculture
Agricultural stocks have the same background support as the energy complex, with long-term demand growing and futures markets getting bid up by speculators. They're also insulated from recessionary pressures because folks have to eat despite adverse economic conditions. But I don't expect these stocks to be safe havens if the broad indices take another dive.

I've been suspicious about the agriculture rally throughout 2008 for one ambiguous reason -- stocks that outperform in one year shouldn't become instant market leaders in the following year. Ag stocks broke this quasi-rule by running higher in 2007 and then finding new buyers as soon as the calendar flipped into January.

Contrast this price action with tech stocks that led the market into year's end and then collapsed in January. Admittedly, my vague discomfort about agriculture isn't a good reason to avoid buying these stocks. But I still have legitimate concerns about the rally's power to hold together through the second quarter.

My thoughts about the group are summed up on the Mosaic chart. The stock is currently trading near an all-time high after breaking above resistance at $118. So far, so good, right? Then add in solid accumulation noted in the green volume spikes that accompanied the recent breakout.

Now comes the problem.

Despite all the good vibes, this stock is trading just 15 points above the high posted back on Jan. 14. In the meantime, first-quarter price action shows 39- and 30-point downswings between the dramatic rally runs. This translates into an abysmal price rate of change (ROC) and a wedge pattern that makes life difficult for Mosaic shareholders.

The downside doesn't sound too bad when looking at the chart and seeing the price bars trading up at a new high. However, the weak ROC exposes an adverse reward-to-risk profile that predicts it will be easier to lose money with this stock in the second quarter than to make it. The issue becomes clearer when looking at other sector leaders.

As it turns out, Potash Saskatchewan , Agrium , CF Industries and other group stocks shows identical wedge patterns. Soberly speaking, these are much better suited to money managers holding positions for months or years than to timing-conscious investors trying to take a good piece out of the long-term uptrend.

There's a second characteristic of wedge patterns that points to additional danger down the road. As the lower and upper pattern lines start to converge, a loss of faith often emerges because shareholders feel frustrated watching deep drawdowns between rally bursts. This conflict can induce a dramatic trend reversal over a very short period.

There's admittedly little evidence that the agricultural rally is about to turn south, especially with the healthy volume noted on the recent breakout. But folks looking for a quick buck who move into this sector will find it much tougher going than trading tech stocks in 2007. As such, I can't recommend new positions at this time.