Over the past few months I have written several articles about signals that have historically indicated that a sector is undervalued. One pattern from the past is that when natural gas prices drop below $2.50/MMBtu, the price generally doubles within two years. This makes natural gas stocks and ETFs potentially attractive. In my presentation at Investing Daily’s recent annual Wealth Summit in Las Vegas, I highlighted these dips below $2.50/MMBtu over the past 20 years:

At that time (mid-May) the price of natural gas was hovering around $2/MMBtu, but it has since increased about 50%. Now closing in on $3/MMBtu, this indicator is no longer the screaming buy signal of recent months. A pullback isn’t out of the question considering that natural gas inventories are at all-time highs for this time of year, so if you missed the opportunity the first time around you could get a second chance.

Another indicator I have highlighted is the yield of the Alerian MLP Index (AMZ), which is a composite of the 50 most prominent energy MLPs. The index includes MLPs involved in gathering and processing, natural gas transportation, petroleum transportation, exploration and production, coal, compression services, propane, refining and shipping, and captures about 75% of the sector’s market capitalization. The index tracking the total returns of AMZ components, including distributions, is known as AMZX.  

The average yield of the AMZ since 1995 is 7.46% (annualized, but recalculated daily). Historically, when the yield drops below about 6% it signals that the sector is becoming overvalued, and a correction ensues. Likewise, when the yield tops 10% it signals that the sector is undervalued. Until last December, this had occurred twice in 20 years. When the AMZ yield exceeded 10% in December 1999, the next 12 months saw the AMZX rally 46%. When the yield rose above 10% in December 2008, the AMZX rose 76% over the next year.

I highlighted this signal back in December in The Loud Message of Fat Yields. Shortly after I did so, on Dec. 14, the AMZ yield went above 10%, so I was able to highlight only the third such instance in the past 20 years in another slide presented at the Wealth Summit:

The AMZ yield spent two days above 10% in December, and then it spent over a dozen days above 10% in January and February 2016. In fact, on Feb. 11 the yield reached 12.01% before retreating.

So was this signal reliable this time around? Indeed it was. If you had purchased the AMZ on Dec. 14 (which you can do through many exchange-traded notes and funds) when the signal was first triggered, you would have realized a total return of 32% thus far. Had you waited until the yield hit 12% you would have realized a total return of 57%, but note that this was a yield that had only been reached once previously.

The AMZ yield has now dropped to 7.26%, below its historical average. Thus, the sector isn’t as deeply discounted as it was a few months ago. The historical 10% buy signal may not be reached again for years, but when it happens again we will be here to remind you to buy the sector. Likewise if natural gas prices again drop below $2.50/MMBtu.

But you don’t have to wait around for buy signals that only come once or twice a decade. To take advantage of in-depth research and winning energy income recommendations, consider subscribing to MLP Profits.

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