If tax rates rise and government spending slows next year, the economy is expected to fall into a recession, according to the nonpartisan Congressional Budget Office. Some political pundits insist that Congress and the president will do all they can to avoid a recession, but economic growth is determined by a number of factors and political will alone has never avoided a recession.
Rather that watching Washington for clues about economic growth, traders can watch oil prices. In the past, recessions have been associated with oil price spikes. In the chart below, created at the Federal Reserve's website, the 12-month rate of change (ROC) is shown for oil prices. The gray bars highlight recessions, a standard feature on all charts created with the Fed's data.
The annual ROC of oil prices has spiked above 80% five times since 1970, and a recession followed four of those spikes. In 2010, however, oil prices rose as the global economy recovered from a deep recession and growth followed the price spike.
Even if there isn't a guarantee of a recession, this analysis still points toward a trade. There are some oil companies that have become extremely overbought, and even if the economy grows strongly, it's doubtful these companies can move much higher. Tesoro (NYSE: TSO) tops the list of short candidates among oil stocks.
TSO owns and operates seven refineries with a combined crude oil capacity of 665,000 barrels per day. This business can only increase profits if oil prices rise sharply. That seems like an unlikely prospect, because while the United States may avoid recession, economists seem certain that it will also avoid strong growth, as will most of the rest of the world. Oil prices rise when economic growth accelerates.
TSO also operates almost 1,400 gasoline stations and convenience stores. Growth is expected to be slow in this segment, as well. Analysts expect TSO to maintain steady growth of about 8% a year for the next five years. It has a price-to-earnings (P/E) ratio of about 8, making it the kind of stock value investors often look at. But one problem that value investors may have is the overbought condition of the stock.
Bollinger Bands have been added to the weekly chart of TSO shown below. TSO closed more than 3 standard deviations above average in mid-August. This is an extreme value that is expected to occur less than 1% of the time. Since then, the stock has been trading within a narrow range. MACD has been declining and on the daily chart (not shown) and has turned bearish.
At the bottom of the chart, the 52-week ROC is shown. Like the chart of oil shown above, peaks in ROC are followed by slowdowns. In the past 12 months, TSO has gained about 103%, an unsustainable level of price growth given the slow earnings growth rate expected for the stock.
TSO has also reached the price target based on a double-bottom pattern the stock formed during the past year. This is a price where traders who bought the stock based on the pattern will be selling, creating downside pressure on prices.
Now seems like a good time to sell TSO and a short trade offers an opportunity to profit from that selling. After a decline, TSO should find support near $29, the price target for the short trade. Risk can be managed by placing a stop at $46.02, about 10% above the recent price.
Action to Take --> Short TSO at the market price. Set stop-loss at $46.02. Set initial price target at $29 for a 30% potential return in eight months (the length of time it took to form the double-bottom).
This article originally appearead on TradingAuthority.com: