We saw a pretty significant signal recently from the oil sector.   A relative strength sell signal.

This does not mean oil immediately becomes a terrible place to have money at work in March or April 2010.

But longer term, it suggests oil will (likely) under-perform the overall markets.  And, it’s possible the sector could significantly under-perform.

This is really important, in more than one way.

First, let me walk you through another example where a sector gave a relative strength sell signal. The Financial sector gave a relative strength sell signal in April 2007.  Think about that.  That signal came before any of the mortgage stocks melted, well before Bear Stearns imploded (nearly a year before that event) and significantly (18 months) before Lehman Brothers collapsed. And long before things like “sub-prime mortgages” and “TARP” became household terms.

And since “financial companies” were the largest component of the S&P 500 (at the time), it was a pretty serious signal for the whole market.

What was even MORE significant was that April 2007 was the first time that chart had flashed a relative strength sell signal…period.

Sure, some financial stocks rallied – and were even good trades AFTER the relative strength sell signal in April 2007.  But those gains were fleeting, and most were only short term trades.   You were trying to swim upstream in downward environment.

What relative strength charts can tell us is which areas will out-perform (or under-perform) their peers (or the whole market). And relative strength signals tend to last (on average) about two years.

Relative strength is not a trading tool.

So, oil, as a sector, has now given a relative strength sell signal. This is important because as the market has improved over the past year we’ve seen some common characteristics: as oil prices climbed, the dollar fell.  Are these two actions mutually exclusive?  Probably not.  However, in some ways, in the last twelve months oil became a proxy for inflation – and for the markets overall.  We saw areas rich in natural resources (like Latin America) perform really well over the past 12 months.

And now, in the last few weeks, we’ve seen the dollar strengthen (somewhat), we’ve seen emerging markets slow down (again, somewhat) and the price per barrel of oil has leveled off around the high 70’s-low 80’s area.

This does not imply oil will collapse with absolute certainty.  After all, the market generally looks pretty virile.  It also does not mean we will absolutely see Lehman-style collapses in the area either.  But never say never.

This is the first relative strength sell signal the oil sector has given, dating all the way back into the 1990’s.

This is one big reason why I have stopped buying in the oil patch and the emerging markets.  These areas were “hot to trot” a year ago.   Now, I am more skeptical about investing in these areas. Too many times, investors will look at “what did the best last year” and blindly stick their 401k money there, or invest in the hot mutual fund of 2009.  Last year’s superstars may become this year’s (or next year’s) duds.

Be careful!  Again, this signal could foreshadow conditions that may not appear for a few months, or even a year.  Or not at all. The sector could just stall.  But I’d rather be early, than a minute late.

Now Go Talk About It!