Weekly Energy Review, Market Outlook and Trading Plan for December 7-11
Dec 6, 2020 Trading Blog
The market has almost reached the 380-400 goal that I’ve been writing about over the last several months. I expect that it will get there in the next couple weeks, but what happens then? This post election and Christmas rally was also expected, but it’s growing old too. One reason I write this article every week is to record what I’m thinking at the time so I can go back and review it to see where I was right and more importantly where I was wrong. The question now is whether or not we get the market reset once the price target has been reached and the celebration of the election is over. Short answer, I think we do, but how big will the pullback be?
Last week, I wrote about a possible coming spike in interest rates and we did get a significant move this week with the 10 year almost reaching 1%, while the TLT took a dive toward the June lows. It’s really not a huge market moving event yet, but if rates continue to move up at a faster than normal pace, the market could get spooked and rates could be the thing that causes the next market pullback. I think traders are soon going to start asking WHY rates are starting to climb. The primary answer is inflation. Can the economy in its current condition absorb price increases while so many remain unemployed? And what happens to prices when (if?) the rush of demand returns on a lessening of virus concerns? Where does the money come from to buy all those expensive houses and cars? Stock profits?
The one market that really seems to be a concern for me is housing. I really don’t think anyone is paying attention to this sector yet and the signal it is sending. House prices are shooting up everywhere. At what point do the price increases force a move up in mortgage rates, which also track the 10 year Treasury? I know we live in a market of FED manipulation, but there are still real market forces out there called supply and demand. I’ve been watching a short ITB trade for the last few weeks and I think there’s a good chance that sector rolls over if rates continue to rise. If rates do rise due to market forces, then house prices will necessarily have to come down. There’s also the possibility that the market starts seeing increasing mortgage delinquencies as employment continues to lag. Remember how that decreasing home price, rising mortgage delinquency combination worked out about a decade ago? Right now banks are offering the cheapest money ever to buy the most expensive houses ever, that can’t end well. Keep an eye on rates this week and whether the bond market is in fact leading the stock market in direction. The TLT has clearly turned down from its uptrend that started in the fall of 2018, which coincidentally was also the start of the ITB uptrend. Do they now trend down together? Does the stock market soon follow with at least a pullback, if not an extended move down? Don’t ignore the ITB signal.
Overall Market Macro
SPY – The move since November 2 now stands at about 15% to the upside. That’s 15 percent in a single month. A single month. At what point do we maybe start considering this to be a blowoff phase in very mature bull market? 20%? 25%? Given all that has happened in 2020, the SPY is up almost 15% for the year. If you knew all that would happen in 2020, would you have taken that bet? Are we melting up in a final move? I think we are and FOMO is running rampant. There are no technicals or road signs on the upside anymore. On the downside, I’m watching 360 and 352. If we do get a meaningful pullback soon, I think the most obvious level would be 322, which is about a 13% move down.
QQQ – Tech broke out of the consolidation pattern that started back in August and closed at an all time high. It’s an obviously bullish signal, but could quickly turn into a bearish one if price fails and moves back into the consolidation pattern in the next week or two. Watch price this week and see if it pulls back toward the 295-298 area.
IWM – This is my short bet. I’d like to get short in the 190-200 range. This one has just melted straight up from 150 to 188 in a single month to all time highs. That’s a 25% gain in a single month and it’s a textbook blowoff top. I will be getting short this week in a very big way for probably my largest sized trade this year. At some point Main Street and Wall Street have to intersect again. When you look at the real economy, unemployment rates and rising inflation, there’s just no way small businesses should be valued at this level. Is it possible that the short trade is wrong here? Absolutely. But I’ll gladly take this trade and if I’m wrong so be it. I think there’s an easy 10-15% profit in the trade as a pullback likely takes the IWM back toward the 170 level. If it keeps moving up, then I’ll keep adding to the trade up to the 210 level.
TLT – The TLT started an uptrend about two years ago, November 2018 and now finds itself testing the trendline from that point, as well as the summer lows of 2020. This is probably the most important watch of the week. If it takes out the 153-154 area and gains speed, the stock market may get a shock from rising rates. If it bounces, then 161 becomes the target on the upside which could establish a short term bottom in rates. I think there’s a real possibility the market is taking rate decisions out of the FED’s hands and that could cause the stock market some stress.
UUP – The dollar continues to weaken with the UUP falling, but there could be support coming soon around the 24-24.25 area. Rates and the dollar are currently competing against each other with regard to the effects on commodities (PDBC). The weaker dollar is pushing the PDBC up, while rising rates are a response to that commodity inflation. Who wins? At this point, I think the market would prefer the dollar to find a bottom soon in hope that commodities would slow their rise, which in turn would likely slow the current rising rates. If the UUP continues to fall at its current pace, then the TLT likely follows and rates continue to rise, which eventually ignites a stock market pullback.
PDBC and GLD – I watch general commodities through the PDBC. There are several different ETFs which measure general commodities, but PDBC has the most liquidity. If you place the PBDC and UUP charts side by side, the inverse correlation is obvious. As UUP falls, PDBC rises. PDBC contains an large weighting in oil and energy, so it does reflect the XLE chart somewhat. The current PDBC move up is reaching a very strong resistance level around 15.00 which started back in 2016. If it breaks that long standing level, inflation concerns will only grow. I think it will break that level. Another clue is the XME, which measures industrial metals and gold. It has moved from 24 to 32 (with gold components negative) in the last month, which is a signal that other general commodities may not be far behind. The one commodity that isn’t cooperating though is GLD. The UUP has moved down sharply, the PDBC up, yet GLD has fallen since August, along with TLT. It should be going up, and up sharply. There’s an argument that traders are bailing on it as a safe haven play and it’s no longer wanted after the vaccine news, but the inflation angle may kick in soon and start pushing it back toward the 195 highs. I started a GDX long on Friday and I’ll be adding to that position if gold does start back up.
So when you put this macro picture together, what we currently have is rising commodities (inflation) being caused by a weak dollar, which in turn has set rates off to the upside with that commodity inflation. And this negative cycle is going on in a pandemic environment where unemployment is at record levels and people are getting behind on their mortgages, rent and other obligations. The real question is how far do these intermarket forces go before they put a stop to the current bull market in stocks? How long can the stock market ignore real world forces? And what happens if you throw in rising gasoline prices, rising food prices and higher taxes? At some point, this fantasy world of Wall Street is going to have to acknowledge the reality of Main Street, but as usual, the opportunity for us as traders to take advantage of this always comes down to timing.
Energy
Sorry that macro review was so long, but that is where most of my attention has been focused over the last month. You have to know where you stand in the larger picture before ever thinking about the narrow energy sector. So how does energy, and the XLE, fit into this macro picture?
As general commodities have risen, so too has the USO. This rise in the USO has been helped along by a weak dollar (specifically the USD/CAD pair), and all this has pushed the XLE from 28 to 41. The sector has also been helped by a rotation trade out of tech (QQQ) and into financials (XLF) and energy. With regard to the larger macro picture, the question for XLE now is how long does the weak dollar and rising PDBC propel the USO, and how long does the rotation trade cause money to flow to energy? If the SPY does have a pullback, how loyal are these recent new longs in energy going to be? Will they throw it all back on the market at the first sign of a pullback or are they long term players? I really don’t know if this energy move has been just a year end fast money play looking for quick returns or if these traders really believe in a long term future for fossil fuels. I think we may get the answer to this question in the next month or two.
On the technical side, XLE has now run 50% in the last month. I’ve seen some good runs in energy over the years, but this is top 10 for sure. I really have no idea how far this goes, but I do think it needs a pullback soon if it wants to establish a dependable long term trend. If this just shoots straight up, the buyers from lower levels are just going to bail and take sizable profits, which leaves many bagholders. I’d much rather see a pullback and a grinding type uptrend than this parabolic move. The XLE is now reaching that early June blowoff area and price could possibly test those highs around 45, but again, the real problem is what kind of structure is it building underneath with this parabolic kind of run? As we saw in June, the parabolic run had absolutely nothing under it, so is this a repeat?
I’m definitely getting interested in a short position in energy soon and it think the opportunity could present itself this week with a simultaneous blowoff in the XLE and IWM. I started a very small short position at 40.50 and I’ll continue to build that position up to the 45-46 area. I have absolutely no desire to get long any individual names way up here. We still have a pretty pathetic economy and there’s no guarantee this vaccine produces the pre-pandemic demand levels. There’s still a huge supply of oil sitting just over the market which has been building over the last eight months. These companies still have tons of debt, bad fundamentals and a current group of declining wells which will need to be replaced. CAPEX is going to have to increase soon if those wells are to be replaced to prior levels of production. Do these companies have the money to increase CAPEX and what does that do to their cash flows? That has always been the problem with shale, they have to replace these quickly declining wells so quickly that CAPEX eats the profits.
One other thing to watch for in energy is secondary offerings. As the equity market continues to advance, individual energy names will surely take this opportunity to come to the market for funds. That dilution could really make some names dangerous, especially the ones who are already weak and need the funds the most. I’d recommend staying away from the lower quality names for this reason.
In summary, this energy run has been nice, but is there any future in it or has it just been a quick money trade in the final blowoff of a very mature bull market? I’ve always seen this market cliche that when energy is your leading sector, the end of the bull market may be at hand. I don’t know if it’s true this time, but given the larger macro picture, I wouldn’t be too surprised if it was. Be careful and really consider the risk you are taking if you get long on these names after this gigantic run.
Trading Plan for the Week – I have only four targets this week: short XLE, ITB, IWM and long in GDX. I’ll be focused on these four and I won’t be trading any individual energy names or any other sectors.
I’m looking for a move up in XLE toward the 45 area to build a short position. I’m willing to stay in this position for awhile and incur some pain in it. While I would like to think the energy sector has bottomed, there are just too many other larger factors that say this is just energy getting swept along with the larger market and not a specific move based on the internal factors of the oil market or the fundamentals of individual energy names. Target on the play is 32-35.
I want a short in IWM in the 190-200 area this week on a parabolic move. The key here is to watch the QQQ/IWM correlation and hope that money reverses flow back to tech and away from small caps, banks and energy. Any acceleration to the downside for TLT would also benefit a short play. Target on the play is 170.
I’ve already tried the ITB short and made a small 3% gain, but price hit my trailing stop and knocked me out late last week. This is still my favorite trade opportunity in the current market. I was hoping for a nice retracement back to the 56-57 level as the SPY made new highs, but the ITB really couldn’t muster any strength at all, which tells me a short is the correct play. This short play depends strictly on the TLT. If the TLT finds a bottom this week, I’ll probably avoid the ITB short play for now. The reason behind this play is that mortgage rates should follow the 10 year yield up, which will force house prices down. Also, as copper, steel and other building materials increase in price, builders aren’t going to make the normal profit margins, especially if house prices fall due to increasing mortgage rates. It’s a really dangerous combination of rising input costs and rising financing costs, not to mention the employment and consumer debt picture. With this current economy, how are banks able to approve this flood of buyers, especially at these high prices and low rates? Are requirements being relaxed like they were in 2007?
The last trade on the radar is a long in GDX. This is the tricky one of the group. I started a long at 35.25 on Friday for a short term trade, but I’d really like to see this fall to the 30-32 area for a longer term play. As inflation starts to become a threat and the dollar continues to fall, gold should soon find a bottom. I think there could be a nice entry window when the dollar finds that first temporary bottom. Usually gold and the dollar move inversely, however GLD has been moving down with UUP and TLT. If we suddenly get a strengthening dollar, that could send GLD/GDX down sharply. If gold is moving down on a weak dollar, then it makes sense that it should move down even faster on a strong dollar. If this happens, then that’s your entry. The window will be very small and will look extremely scary, but you have to plan for it and execute without thought when it happens.
That’s the plan for the week. It’s mostly going to be a week spent waiting and watching for these four setups to form optimally. This is a dangerous market and FOMO is getting out of control for the crowd. Watch sentiment and be ready for the turn. This could be the final blowoff in a very old and very extended bull market. Good luck this week.