Jesse Livermore was perhaps the most famous stock trader of the early 20th century; he made and lost millions of dollars in his day. And, for the record, that was a lot of money 100 years ago. Livermore was most famously immortalized in Edwin Lefevre’s thinly veiled biography Reminiscences of a Stock Operator, probably one of the best and most helpful books on trading and investing ever written.

One of Livermore's trading rules was “Be right and Sit Tight.” He also said this is one of the hardest lessons for any investor to learn. In other words, Livermore suggested jumping on board a major trend and then having the courage to hold on to make the really big gains.

Clearly, energy is just such a major trend. As I've outlined on numerous occasions in The Energy Strategist, demand for oil and gas is booming while the world's ability to expand supplies and production is, at best, limited. The great commodity bull markets throughout history have lasted for at least 15 to 20 years--this current up-cycle has more than a few good years left in which to run.

But that doesn’t mean there won't be corrections. Long-term readers are well aware that we've seen three significant energy corrections during the past 12 months. Each pullback lasted between one and three months and resulted in prices 15 percent to 25 percent off the highs for most stocks in the group. Each pullback also represented an excellent buying opportunity as the group subsequently rallied to new highs.

The important thing to remember is that no great bull market has been immune to such corrections. Even the Nasdaq in the 1990s and gold in the 1970s saw corrections of as much as 30 percent in the context of a longer-term trend higher.

These corrections make following Livermore's “Be Right and Sit Tight” rule so difficult. All too often, investors panic and get shaken out of the market during these corrections, thereby missing out on the even greater returns to come. At the same time, investors are correct to want to protect their gains; after all, making big money on a stock only to watch it evaporate is a sad strategy indeed.

By late April even energy bears were giving up and jumping into the sector; greed and the desire not to miss out on big gains were the prime emotions driving the market. Technical analysts (also known as chartists) term such action a "blow-off top." Normally this sort of parabolic rise and fall leads to a correction that lasts for a few months.

It seemed rather odd to be speaking of a downturn with oil near $75 and energy stocks breaking to new highs.

While the fundamentals for the group are undimmed longer term, I’m not convinced we’ve seen the lows of this correction. Every great bull market in history has seen periodic vicious corrections of as much as 30 percent before ultimately rallying to new highs. It’s these ugly sell-offs that tend to shake out investors at just the wrong time; investors panic near the lows and bail out of their investments.

And it’s been a long time indeed since the oil and oil services names have corrected to that extent. I suspect we’re currently in the middle of such a cathartic sell-off that will end in a bout of panic-driven selling. Eventually this will offer another top-notch buying opportunity, but we’re not at that ideal buy point just yet.

How To Play It

Our first line of defense is to stick with more defensive sub-industries within energy. A perfect example of a defensive group is the master limited partnerships (MLPs) and pipeline plays. These income-oriented investments don’t move in line with the rest of the group.

Specifically, when energy stocks were red hot earlier this year, investors totally ignored these “boring,” slow-moving MLPs. But when the energy patch hits a periodic correction, money tends to rotate out of the growth-oriented energy plays and into the steady eddies like the pipeline MLPs.

In addition, the pipeline companies are getting some attention from private equity firms due to the Kinder Morgan buyout plan; speculation regarding the potential for more deal-making activity is helping to put a floor under the group.

While not totally immune to a pullback, the pipeline and coal MLPs I outlined in the most recent TES are the most defensive buys during this pullback.

Our world is mired in a perpetual energy crisis. Common energy investments will yield uncommon profits in this new Gilded Age. I would like to serve as your guide going forward, helping you to minimize risk and maximize profits in the financial markets.

You be the judge, okay. Don’t let the greatest energy bull market this century pass you by.

Best regards,

Elliott H. Gue
Editor, The Energy Strategist

© 2006 Elliott H. Gue
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