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Weekly Energy Sector Review and Market Outlook

Hope everyone had a great Thanksgiving week. It was a nice vacation and some much needed time off. I’m ready to get back to trading this week. Before jumping into the regular top to bottom energy macro analysis, I took a few minutes this morning to examine the areas that were NOT moving this past couple of weeks. Sometimes the clues don’t come from what is moving, but rather what should be moving, but isn’t.


There are a few areas of the market that might be offering some signals for what we might see in the next few weeks, specifically Homebuilders (ITB), Mortgage Securities (MBB) Utilities (XLU), Gold Miners (GDX) and Real Estate/REITS (XLRE). As the overall market has advanced sharply, these areas have lagged or even moved opposite the larger market picture. The question is, what are they trying to tell us?


The common theme among these sectors is interest rates. The fact that these sectors are fighting the overall market direction means that something is holding them back and I think that something is a coming increase in interest rates, which could be a warning for oil and equities. The most common interest rate indicator I follow is the TLT, which represents longer term rates and also has the most bearing on inflation. It’s an interesting picture if you compare the TLT chart with the TIP chart. I think the most sensitive sector out of the handful that I have chosen is the homebuilding sector (ITB). That chart really looks like it might be about to top out and roll over and that makes perfect sense if you assume that interest rates are about to rise sharply. Higher mortgage rates make houses more expensive and less obtainable, which may be why this chart looks to be putting in the famous head and shoulders formation. Real estate (XLRE) is the same and of course utilities (XLU) is not something you would want to own in a higher interest rate environment either. Of the eleven SPDR S&P 500 sector ETF’s, utilities had the worst performance since this market run started on November 9.


One curious area that requires attention is mortgage securities. The largest ETF for this is MBB. That instrument has been falling since May and that’s even with the FED buying heavily in that ETF. They are trying to hold price high (rates lower) to promote homebuying, but the instrument is still moving down. If rates start to accelerate to the upside, this one could fall sharply and take ITB down with it. One other thing that I thought was interesting is that if you look at mortgage rates these days, the 30 year fixed rate is LOWER at some banks than the 5/1 ARM. That just shouldn’t be, but I’m not exactly sure why this is happening. Are banks (or the FED) discouraging ARMs?


These hidden interest rate warning signals that are flashing in the market need to be respected. If rates are about to spike, and I’m not saying they are, then risk management in equities needs to be tightened and extreme caution used. If anything is going to bring this market down, it’s a spike in interest rates, whether market forced or FED forced.


Macro Picture for Energy

With that warning out of the way, let’s take a look around the macro picture for oil and try to figure out what to expect this week. The SPY just continues to grind higher and the QQQ decided to join the party last week by breaking out of a pennant type formation which started back in August. I think the more important indicator of the two for the energy sector is the QQQ. If tech really breaks higher this week, the tech to cyclicals (XLF/XLE) trade could pull back sharply and force the XLE to pullback and digest some of its gains. If the QQQ fails and heads down this week, then it’s possible that the XLE could grind higher. The real question here is how long does this tech to cyclicals rotation continue?


One clue for the rotation can be found in the other cyclical area that has been climbing along with energy, the XLF. The banks have a benefit that the XLE doesn’t have and that’s higher rates. As rates climb (TLT down), financials perform much better on margin interest income. This week it will be interesting to see if the XLF and XLE finally start to diverge. If rates stay flat or rise and the XLF starts to fall, then I think you have to get out of energy in the very short term. However, if there’s any divergence where financials fall and energy grinds higher, that would be an incredible show of strength by energy.


The next clue for energy is the IWM. Small caps have been the strongest part of the market and have correlated very well with energy for the last several months, but at some point this run needs a rest. During the month of November, the IWM has moved from about 151 to 185 and that’s an extreme move for such a larger portion of the market. I wouldn’t be surprised to see a pullback to at least the breakout point around 170. Since the IWM and XLE have been so correlated, any pullback in small caps should be accompanied by a pullback in energy. Keep an eye on the QQQ/IWM correlation to see which is stronger as an indication of the tech to cyclicals rotation. If QQQ opens the week strong while IWM lags, then it’s probably time to get cautious on the XLE.


I base my macro market view on correlations, but one important thing to know about this approach is that correlation DOES NOT equal causation. As I compare all these different market areas, I’m not saying that all these moves cause or are caused by other areas. The only goal is to use these correlations to notice when things change or when relationships don’t make sense. The underlying “why” is often very difficult to ascertain. As an example, one correlation really has me stumped right now and that’s the Dollar (UUP) to Gold (GLD) correlation. The weakness in the dollar has been providing a tailwind to oil lately and that same tailwind should be showing in gold, but it’s not and I really can’t explain why. A weaker dollar should indicate higher gold prices, especially since other general commodities (PDBC) are rallying on the weak dollar. Gold is suggesting that the dollar may be getting ready to firm up and bounce in the near future, and if it does, that could be a warning for oil. I posted a UUP/USO side by side comparison chart Friday which shows an almost perfect inverse correlation. If UUP starts to move up, then USO should start down.


One other relationship that might also be offering clues is the TLT/GLD correlation. They have moved together for months and what we have been seeing is gold moving lower on rising rates, yet other commodities are moving up. The GLD/PDBC divergence is confusing. If there really is a chance of inflation picking up (as indicated by rising rates) then gold should be moving up with the other commodities, yet it’s not. The only other reason might be if the recent GLD rise was heavily caused by a safe haven type of trade. There was a fairly large gap down in GLD on the November 9 vaccine announcement. That’s really the only reason I can show for why gold has diverged so much from general commodities. The important factor to keep in mind here is that gold could be leading the other commodities, so keep an eye on the PDBC to see if it turns down along with any move up in rates.


In summary, the clues are pointing to a pullback in energy this week. If the UUP bounces, the TLT rises, XLF falls, QQQ rises, IWM falls or USO falls, then energy names could get hit. A positive picture on Monday morning would be a flat QQQ, higher IWM, lower UUP, higher XLF and a lower TLT (although TLT is the tricky one).


Energy Sector Technicals

I’ve stayed away from individual energy names over the last couple weeks. The only trades I have on right now are a short on the XLE with an average of 39.90 and a long on GDX with an average of 33.50. I’m still scaling in on these, so I’ve only got partial positions right now. I think the XLE finally pulls back this week, but I’m not sure how much. The most obvious level for any pullback is the 35.50-36 area. That would correspond with the gap up last Monday and last week’s lows. It would also correspond with the VWAP from the November 9 move which sits at 35.50. If you average all the buying since November 9, the volume average weighted price is 35.50, so that’s a pretty strong indicator of fair value. That fair value level would also be about a 38.5% Fibonacci pullback of the November 9 move. If the sector truly is strong and this isn’t just a fast money rotation trade, then price really shouldn’t drop any lower than that.


The next level down in the XLE would be the 34.50 area, which corresponds to a little over 50% pullback of the recent run. If that level fails, then the sector is probably in trouble and the only level that can save the day is the 32-32.50 area. It would pretty much be a complete disaster if 32 failed at this point. Something really bad would have to happen to cause a move back into that November 9 gap. Maybe an OPEC meeting surprise?? If XLE gets back in that gap, I’d say it’s probably headed for new lows, however I really don’t see much chance of that happening.


On the upside, the first level to watch on Monday is last week’s high at 40.42. The only important area above that is the 41.86 (Friday March 6 OPEC meeting gap) to 41.93 (June island reversal) area. If price can clear that small range area, there’s really nothing stopping a run for the June highs.


MajorsXOM continues to lag CVX. These two have traded near 2:1 in price, however CVX has recently extended that to 91:40. Perhaps the difference in opinion has been caused by the CVX still be indexed to the Dow as it surged past 30,000. RDSA has been the second strongest, while BP is dragging up the rear again. I still like XOM for a longer term trade, but I really need it to pullback significantly to get interested. I’d be interested in the 35-36 area.


E&P – These have just ripped over the last three weeks and there’s nothing attractive about these prices. They are priced to perfection right now and the only people who could profitably touch them at this level are investors who plan on trying to capture a multi-year run, and that’s definitely not my style.


Services – Same story as the E&P’s only more so. The only possibility that I see for a shorter term trade is NOV on a pullback to the 11-12 area. SLB, HAL and HP have all run so far that buying at these levels in the short term just isn’t possible.


Refiners – This was the trade I wanted the whole time, but I missed it. The group will be my primary watch if the sector pulls back in the coming weeks. I really doubt that I’m going to get a buyable pullback, but I’d be interested in MPC in the 33-34 area, VLO 48-50 and PSX 55-56. The vaccine news really treated these well since they are closest to the actual consumer.


Trading Plan for the Week – I’ve got my XLE short position and I’ll probably spend Monday just watching that to determine whether a pullback is actually in the cards for energy or if price is going to grind higher. We’ve got an OPEC meeting this week and the March meeting is still a fresh wound for many traders, so I expect that traders will be cautious early in the week. The price action might take until Wednesday to take a defined direction, so the best move this week is probably patience. If price grinds higher, I’ll just let it climb and continue to scale into the short up to 43 as planned. If we get a gap up and fail, then price is probably headed down for the week. This week really all depends on the OPEC meeting and the macro factors discussed above. The dollar, tech and rates will control the picture. I won’t be trading any individual names this week, as I’m more focused on the bigger picture for the month of December. I usually taper down my trading during the first two weeks of December and then take a couple weeks off at Christmas.


So, not much to do in energy this week, but there are other opportunities in other sectors. I’m definitely considering starting a short position in the homebuilders (ITB) and some of the associated housing services like Z and RDFN. Some suppliers might also be attractive like MAS and LPX. Two names that might also be interesting for shorts related to the homebuilders are HD and LOW. Specifically, HD is sitting right on a nice support area that corresponds almost exactly with the support area in ITB. Those two could break lower together or even offer a long trade if the downside break gets solidly rejected.


I’m also long GDX, but I’m really not crazy about that position right now and I’m probably not going to add to it this week. I’ve got an average price on the trade of 33.50 and I’ll probably put a breakeven stop on it there for the week. If it takes that level out, then I would imagine it will make a move toward that 30-32 area for a better trade.


I don’t often get involved in tech, but AAPL is a watch this week as it continues to wind tighter in a consolidation pattern. I think this becomes attractive in the 108-110 area for a long play, but with very tight risk control and if it takes out 105 you have to let it go.


My last watch this week is the USD/CAD pair. I’m looking at getting long for a bounce in the dollar. If I can get something under 1.2950, I’ll probably start scaling in for a move up. As I said before, gold and rates are giving the signal for a stronger dollar, and oil is stretched to the upside, so price could be getting ready for a big move up in the USD/CAD.


It’s Sunday morning and I’m off to get a Christmas tree with the family. It could be a really slow week and energy might be a bit disappointing, so it’s one of those weeks to be really patient and let things play out. Keep tight control on the risk. Good luck this week and be safe.

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