Weekly Energy Review and Some General Trading Thoughts
Nov 22, 2020 Trading Blog
What they say about trading is true, it isn’t you against the market, trading is a battle with your own mind. Anyone can read a chart and recognize where the levels are and what direction price is heading. The real trick is being able to trade that external chart without your own internal bias interfering. I’ve managed to mostly win that battle over the years, but I’m definitely not undefeated during that time and the last couple of weeks I have lost that battle. I know which way price is going and what the chart clearly says, but my mind has a totally different opinion about what is going on in this market. As I said in last week’s writeup, I am conflicted, but standing aside and just watching the action this week has been incredibly helpful. I’m probably not ready to jump back in head first, and I’ll be taking this holiday week off as well, but I’ll definitely be sticking a toe back in soon. Sometimes the correct move really is to step back, take a deep breath, organize yourself and then proceed.
In trading, one of the more troublesome biases isn’t really a bull or bear bias, but rather a recency bias. Let me see if I can explain this clearly, because it has been a problem that I’ve encountered in the past that might help someone else. I mostly daytrade a single sector and sometimes when you get so focused on what is currently happening in the day to day moves, you lose sight of the larger picture. Sometimes you expect the most recent moves to be the true and correct price, when in fact the bigger picture has changed, or was always wrong. If you continue to anchor your thoughts to the most recent prices, you miss the larger picture moves because you can’t change your view.
I think what has happened to many traders, myself included, is that we focused on the day to day energy stock prices and anchored ourselves at ridiculously low price levels and we began to accept those prices as true and correct, when in fact they may have never been correct to begin with. However, if you focus on something day after day after day, you forget to even ask yourself if those prices are correct, you just trade them on the assumption that they are correct. When you do this, you leave yourself susceptible to larger market moves like we saw in energy the last two weeks. That move from 27 to 37 was ridiculous, or was it? Maybe this group was always underpriced, yet we focused so much on the recent day to day fluctuations that we never saw the bigger changes. We set our mental price anchor at a level that wasn’t correct. And then the price adjustment happened all at once, not because of some great change in the fundamentals, but because the overly depressed price was never correct to begin with.
I think that was my mistake with this most recent energy move and the reason I didn’t catch it. The fundamentals of the energy sector haven’t changed, yet the price changed in a very big way, and that caused a very big conflict in my trading and put me off my game. Many times when we trade, we expect a change in fundamentals to produce a change in price, yet the opposite isn’t always true. The only way to fix this kind of conflict is to take a break and move up a level to the bigger picture. Pull up the anchor, look around and get your bearings, set yourself and then put the anchor back out based on the new market information.
My second mistake was becoming fixated on how the overall trend in the market SHOULD change. I knew there was a trend change coming and if you read the last couple months of writeups I have been looking to get long in a big way for the coming move up. The mistake was that I thought this market downtrend would end with a final washout to the downside with an extreme volume capitulation that would wipe out all the weak supply and allow the market to then trend up. But instead, the downtrend ended with an extreme gap up on incredible volume that wiped out all the weak supply, thereby allowing the market to trend upward. That gap up change in trend is not common and it really isn’t something that you can practically trade. But it does occasionally happen. If you go back and look at a thousand charts, you won’t find this type of trend reversal in very many of them. As a trader, all you can really do is trade things that are tradable, like a downside washout. There really just wasn’t any way to know that the market would change with a high volume gap up. You trade what you can and don’t beat yourself up too much about the moves you miss, because they weren’t catchable to begin with. Had the sector made a high volume washout to the downside, I was there, but it didn’t so all you can do is let it go.
Success in trading isn’t necessarily about catching all these big pivot moves. The real trick to staying in the trading game is the skill to be able to adjust to the big pivot moves (and avoid the adverse side of them) and then re-enter the market to resume normal trading. And even if you do get caught on the wrong side of big pivots, the true skill needed to survive is the ability to withdraw from the market and re-evaluate. Simply take a break and get your head right. I’ve found that trying to power trade through these moves with shaky psychology never works. Some people can adjust quickly on the fly, but I know that isn’t a strength of mine. I know I have a weakness in that my overall view of certain markets is sometimes slow to adjust. Taking a break is really the only move to protect against that weakness. There’s no shame in taking a step back, clearing your head and then coming back, the market will always be there.
So where does the energy sector go from here? The XLE has recovered about five months of selling in about ten trading days, so naturally the correct assumption is that it’s due for a pullback. The depth of that pullback will tell a lot about the true health of the energy sector. At this point, I have no desire to chase price up here and I’m content to sit and let the pullback happen and then make a decision about what to do. I think if you chase this rally, the trades become extra expensive and highly risky. The market is hyper sensitive right now. What if there’s a disappointment in the vaccine or some other external negative event (there are still unknown unknowns out there)? I could see the XLE easily giving up half these gains in a single gap down and that’s not a risk exposure I want.
Technically, there’s also a chance that what we are seeing in the sector is a larger picture accumulation rather than a true trend change. We got the selling climax back in March, an automatic rally in April/May, then a pullback to retest the selling climax lows in September/October. We could be looking at a long term sideways range between 30-40 for the next 6-9 months. We’ve had the big price change, now I think traders could take a rest and see if the fundamentals adjust also. If things get better in energy, there should be price discovery above 40. If things start to drag again and the lockdowns dampen the economic picture, then I wouldn’t be surprised to see price come back down and test the bottom of the range around 28-30 again. As for whether the lows are now in, I really don’t know. I do know that my view has adjusted. A few weeks ago it was my opinion that we had NOT seen the lows yet, but that gap up wiped out a huge amount of weak supply, so are there really that many sellers left that could take it down? On the other hand, that buying was likely concentrated in a few buyers, therefore if they do stop buying, or worst case if they start dumping it back on the market, then how far down do we go? I still think there is a chance that the low isn’t in, but that chance is much smaller than it was before the big gap up a couple Monday’s ago. I’m just not ready to say the lows are in yet, because if this really is a larger picture accumulation, then there will be a shakeout before the real and final trend up.
The Macro Picture
The week off has been informative. I’ve focused strictly on the bigger picture macro all week and have noticed a few things. The most important thing in this market right now seems to be which direction the dollar wants to take. It’s at an important pivot point and the next move will likely control equity market direction for the next several months. So many individual currencies are at longer term inflection points and this could impact stocks. Pay attention to whether the media starts to focus more on dollar direction in the coming weeks. The UUP has been forming a large base near lows since late July and closed Friday right at the bottom of that base at 24.93. The UUP has trended down (weak dollar) since March 23 while the SPY has trended up since March 23. What happens if the UUP breaks out of this base to the upside? And if you look at the QQQ or SPY charts, they too have been in somewhat of a base, just like UUP, near highs for the last few months. If UUP breaks out of its low base and trends up, does that signal that SPY/QQQ will break out of their high bases and trend down? How much of a headwind would a strong dollar be to US stocks?
If the direction of the dollar is important, then what clues might tell us which way it is going to break out so we can position correctly with stocks? The most dependable correlation with the dollar is usually GLD and GDX. The falling UUP (weak dollar) has pushed GLD straight up since March. If the correlation remains true, then a move up in UUP should produce a move down in GLD. However, if you look at GLD and GDX, they have already topped out and have been moving down. The AUD/USD specifically could also be topping out in the .73-.74 area, which would be a further negative correlation for GLD. Is this failure by GLD (and AUD/USD) an early signal that the dollar is about to strengthen (UUP breaking out to the upside)?
The EURO is the most prominent currency in the DXY, and just like the UUP has been stuck in a base since August, the EURO has also been stuck in a base during that time. Watch that 1.19 level for a breakout or rejection. If 1.19 fails again, then 1.16-1.1650 becomes the downside watch. The GBP is also looking at a big breakout level around 1.34-1.35. If it fails there, the pullback could be sharp. The YEN is really trying to base around 103.50 and if it does there’s a big downtrend line from 2015 that could be broken for a huge move back toward 1.10. The weak dollar has been an important tailwind for the SPY over the last few years and I really don’t know how it will perform if the dollar changes direction. All I do know is that many of these currencies are at really important inflection points and that could have a large impact on the future direction of stocks.
With currencies in mind, watch the USD/CAD this week. Much like the AUD/USD offers clues for GLD, the USD/CAD does much the same for USO. The CAD is sitting on a major level around 1.30 and could make a big move soon. That major 1.30 demand level for the CAD corresponds to major upside supply level of 43-44 in WTI (29.50 in USO). A breakdown of this 1.30-1.34 range would be a positive signal for oil, however if 1.30 holds and the CAD starts upward along with strength in the UUP and currencies above, then commodities, including WTI, could suffer. Keep an eye on the CAD/USO correlation over the coming weeks.
Besides the currency and commodity correlations, the TLT could be offering some useful signals for stocks as well. If we go back to November 9, which was the day XLE gapped up, the TLT has been moving straight up since then and now appears to be trying to break out of its larger picture slow grind down which started early August. Also, notice that GLD also started it’s slow grind down on the same date as TLT. Bonds and gold may break back to the upside together (implying a weak dollar), which could be a good signal for stocks. While these correlations can diverge at any time, they do offer good background signals. The divergences themselves can also offer good clues.
As for the equity indices themselves, SPY and QQQ remain in a consolidation, however the IWM has broken to the upside. The important watch this week will be how IWM handles a pullback to the breakout point around 170. The QQQ continues to evolve into a tightening triangle since topping out in early September and the upside points to watch there are 294 and 300. For the SPY, much like the IWM, it should pullback toward its recent breakout point around 350-355, at which point it will offer some good clues about the underlying strength and whether or not this election/Christmas rally is out of steam. While I don’t think there’s any real danger of a big breakdown in any of these indices, they could fall back into a consolidation range and be very difficult to trade.
I think the most important stock sector this week will be the financials (XLF and KRE). The pullback in TLT, which began back in August, has fueled a nice run in the bank stocks, but it will be interesting to see if a larger picture move up in the TLT (lower rates) will stall that run in the banks and move money back to tech. It’s difficult to determine how much of this move in financials has been due to the tech to banks/energy rotation and how much has been due to rates creeping upward. Banks and energy stocks have moved together on this latest move up, so if financials start to diverge to the downside, that could be a signal that energy could be running out of steam.
As for energy itself, I really tried to divert my attention from the individual energy names and keep my focus on the larger picture last week. It’s been an amazing run, but the XLE is hitting that summer range and also the 200 day ma, so it may be time for a pullback to see just what kind of demand is now under this sector. The levels on the downside to watch are 35 (last week’s low), 32.50 (prior week’s low) and 30 (original demand level for this entire move). There’s also a minor level around the 50 day moving average around 31.25, but if price falls that much this week I doubt that level would stop anything. I don’t have any trades setup this week, but if price somehow makes a crazy move toward 40, I’ll start in short. If we get some type of major pullback, I’d be willing to start in long at 30. Like I pointed out earlier, we may be looking at a longer term consolidation range of 30-40 over the next few months, so playing the edges would be attractive.
I’ll probably stay off Twitter again this week, and honestly it’s been a great break from the distraction of social media. Sometimes I think we don’t realize how much mental energy we waste on social media. It has its purposes and can cure boredom, but often those advantages are heavily outweighed by the disadvantages of distraction, anger and confusion with the opinions of others. So I’ll be watching the big picture again this week and I’ll pop on Twitter if I see any good trades in the macro. Hope you guys have all been having good trading results and I wish you a Happy Thanksgiving with your families.