When Buying Record Lows Makes Sense

This week's chart is going to have a very different look from what we normally share in our Chart of the Week column. From time to time we cover an interesting chart that is at a key inflection point but usually we employ a top-down approach and focus on pointing out the strongest structural trends across markets. This week we have a counter-trend setup in what's consistently been the weakest area of the US Equity market, Energy. Most Energy sector and subsector ETFs topped out and have been in a downtrend ever since Crude Oil rolled over in mid-2014 and fell over 75% to its early 2016 low.

For context, the average Large-cap Sector SPDR ETF excluding Energy ($XLE) is 4.5% below all-time highs; meanwhile, XLE is ~60% below its record highs from 2014. This underperformance only becomes more pronounced as you move down the market-cap scale, with Small-cap Energy ($PSCE) 529% off all-time highs while other small-cap sector ETFs are only ~18% off their record levels, on average (percent off highs are calculated using current price as the denominator).

This 5-year performance chart illustrates just how poorly Small-cap Energy has done relative to other small-cap sector ETFs since prices peaked in 2014. PSCE has lost almost 84% of its value while every other small-cap sector is positive over the same timeframe.

We finally saw a drastic change in character this week as PSCE was up almost 10%. This represents impressive short-term relative strength vs the average small-cap sector ETF and the S&P Small-cap 600 Index ($IJR), which were each up just over 1%. I know what you're thinking... one week doesn't make a trend, right? While this is true, there are some other things going on with PSCE's chart that make this a compelling setup. We have a positive momentum divergence on both the daily and weekly timeframe as well as a potential double bottom at a major support level marked by prior all-time lows from Q4 of last year. Here's the weekly chart.

Notice how price slightly undercut its Q4 low this week before engulfing its entire prior week's range and closing above its prior week's high. This is often referred to as a key reversal week and used as a short-term trend-reversal signal. The fact that this occurred at all-time lows and in the context of a bullish momentum divergence only adds to the weight of positive evidence for this setup. With price below a downward sloping 200-day and momentum in a bearish range, this is not the type of trade we'd usually be interested in, but because we have such a clear level of support to define our risk against, a mean-reversion trade makes sense here from a reward/risk standpoint.

PSCE has about 35% of upside to get back to its year-to-date highs of ~11.75. Compare this with ~8.5% of downside back to all-time lows and this setup produces a favorable reward/risk ratio of ~4x. If you are looking for other opportunities in the Energy sector, Oil Services ($OIH) and Natural Gas ($FCG) look quite similar to PSCE as both are also bouncing off fresh all-time lows with bullish momentum divergences.