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Weekly Energy Equities Review, Market Outlook and Trading Plan for June 21-25

Sorry for not posting the writeup the last few weeks, I’ve had high school graduation stuff going on almost every weekend, and honestly there just hasn’t been much to write about. The last couple of months have just been a slow grind upward, but last week’s FED meeting threw a curveball and now we might actually start seeing a two way market for awhile.


So what happened with the FED? I think they finally reached a tipping point where inflation went from a lower probability event to something that is probably a very high probability event. Inflation has been a fear for years, but it seems like it never fully develops, however this time I think they sense that they have taken a step too far with QE and inflation is now inevitable. The question now is whether it’s transitory or permanent. The market responded by taking a step back from the inflation trade. I think many traders entered the inflation trade thinking the FED would let the economy run hot for an extended amount of time, however Wednesday’s meeting may have changed that view as the FED showed some willingness to step up and fight the inflation battle in an attempt to keep it from getting out of hand. As a result, we saw all the commodity plays take a step back, including energy stocks.


So the question now is, how many steps back do traders take and how long do they let these commodity plays pull back before they hit them again for another run up? Short answer is that I don’t think they are going to let them pull back very far. In the XLE, I think the pullback goes to the 50-51 area, which would be about a 10% pullback from the high of 56.54. At worst, the pullback could go 47-48 (about 15-17%), but I really don’t see any way it goes below that. There’s just too much short term money out there willing to gamble.


I’ve been pretty bearish over the last few weeks, but as I’ve tried to explain over and over, I’m not bearish on the direction of energy stocks. I’ve been bearish on the trade in energy stocks. If anyone missed the baseball analogy in my Twitter feed, go back and give that one a read. Gambling isn’t about who wins the baseball game, it’s about what kind of odds you get on the bet. Same for trading. I see guys hugely bullish and piling into the XLE in the 55-56 area, but as I kept pointing out, that was a really bad trade and the reason I’ve been bearish. There’s a huge supply level at 60-62. The entry at 55-56 only has the opportunity to give you 5-6 points of profit. However, as many are now finding out, the downside is probably bigger than 5-6 points. This was the situation I’ve been telling people not to get into, and therefore the bearish outlook.


So what would turn me bullish? A pullback to the 50-51 area would flip me from a bearish outlook to a bullish one. And it has nothing to do with the direction of the XLE. The ultimate target is still 60-62, that supply level hasn’t changed. However, now the entry is in the 51 area, which gives about 10 points of profit rather than the 5-6 points of profit that other guys were getting with that 55-56 entry. But the real reason to turn bullish is the risk side of the equation. With a 51 entry I can probably get away with a 1 point risk for a short term trade and a 4 point risk for a long term trade. So now, instead of risking 5-6 to make 5-6, I’m risking 1 to make 10. This is why I’m hugely bearish at 55-56, yet hugely bullish at 51. It’s not about the direction of the XLE, it’s only about the odds on the bet. I know it only seems like a few points, but the odds at 51 are astronomically better than the odds at 55-56.


The risk of 1 point for a return of 10 points is a short term trade for me. However, at 51 I could even justify a longer term trade now. The risk for a longer term trade would probably be 47, which is about 4 points. The reward is still 10 points to the 60-62 level. That’s a risk of 4 to make 10, or about 2.5:1. That’s an incredible upgrade from the 55-56 entry where you are risking 8-9 points to make 5-6, or about 1:1.6. By being patient and waiting for the pullback, the entire trade has changed from bearish to bullish. Again, I’m not some crazy permabear basing my opinion on the direction of the XLE, which is clearly going up. I’m a trader who sees the bet only in odds, not direction.


I hope that kind of clears up why I was bearish at 55-56, but bullish as things pullback to the 47-51 area. It has nothing to do with the quality or fundamentals of energy stocks, only the odds I’m getting on the trade. So with that out of the way, let’s take a look around the market for the upcoming week.


SPY – The SPY has started a pullback, the question is how far. Price closed just below the 50 day moving average on Friday, so there is likely going to be a bounce on Monday or Tuesday to test the 50 day from below. The price action on that test will reveal a lot about what kind of pullback this might be. The first level of demand below the 50 day is around 405. Next level down is around 390. That’s still only about an 8% pullback, which isn’t much, especially considering the run up we’ve had in the last few months. A 10% pullback would take the SPY to around 382, which just happens to be where the 200 day moving average sits. I’m really not sure what kind of pullback this might be, so just have to be patient and let the market tell us.


QQQ – Tech was stronger than SPY and IWM last week. There might be a couple reasons for that. As the inflation trade has grown, money has moved from growth areas like tech to value type areas like banking and energy, as well as small caps. That rotation was clearly reversing after the FED meeting. Watch the QQQ and IWM correlation. One other reason for the strength in QQQ as the SPY moved down is that many see mega cap tech as a safe haven. If you have to be invested in the market, many consider tech the best place to be. It’s almost like the safe haven role that gold used to have in the past. There is always that chance that they all go down together, but see if QQQ maybe shows a little more resilience this week than other areas.


IWM – This is the area of concern for anyone trading energy. Small caps, banks and energy have been the darlings lately and have moved roughly together for quite a bit of time. It really looks like IWM might be topping out and rolling over, which is a big red flag for KRE and XOP. I’ve posted a few charts on the IWM showing the probable price path and it looks like that prediction might be coming true. There was clearly a double top around 234. The real key though is the action at 215. There’s a neckline that extends back  to January 1 that has been tested four times already. It looks like it might be headed for test number five this week. If the 215 level breaks, there’s nothing to stop a fall to the 175 area. That congestion area from mid-February to present is really looking like a Wyckoff distribution pattern with that recent 234 move being an upthrust formation. If IWM breaks the 215 level with big volume, that probably pushes XLE to test 47, so IWM needs to be the main watch for the upcoming week.


TLT – Bonds are making a big move up, but should hit some supply around 148. As money moves out of stocks, it’s finding a home in the safety of bonds. I’m not interested in trying to play TLT long, the trade is just too difficult. Given the FED’s position on raising rates a little sooner than expected, it’s a little curious as to why bonds are going up. The most useful signal coming from bonds is the effect it has on banks. As bonds rise, bank stocks fall, and as I’ve pointed out a few times, banks and energy have been moving together. Falling bank stocks probably isn’t a great sign for energy. Also, banks are about a 15% weighting in the IWM, so if banks fall, that likely drags IWM down. I’m looking for TLT to top out this week around 148-150.


GLD and UUP – The most damaging thing for commodity names this week was the incredible strength in the dollar after the FED meeting. The UUP (DXY) closed above the 200 day, so this could be a  longer term trend change. GLD took the brunt of the hit, losing about 6% in a little over two days of trading. I think this sets up a nice long trade in GDX early this week. I’ve posted the UUP chart a few times in the last few weeks pointing out the double bottom possibility. That formation has been developing since December 2020, so the recent move up should have been expected. The FED announcement probably lit the fuse for that move. The UUP should find some resistance somewhere between 25.25 and 25.40, but then it probably moves back down to test the 200 day ma from above. As for GLD, it gets really attractive in the 160-162 area. I rarely play GLD, but I do like GDX as the play on gold.


XLF and KREKRE is in an interesting spot this week and it’s an important watch for energy traders. It’s sitting right on demand around 63.50 in a formation that has been developing since mid-March. If KRE breaks down, the next level is around 58. If KRE breaks down, XOP likely follows. Watch the banks/bonds correlation this week for clues.


Energy, XLE, XLE, USO

There was a curious divergence last week in energy names. The money seemed to flow out of almost all large cap names, but my energy stock list did have a good amount of small cap names that were still green. My core energy list has 35 large cap names and all of them were red Friday. This suggests that the current pullback was probably larger funds adjusting their inflation trade. Many of the smaller names just aren’t widely held by funds playing the inflation trade, at least not in size. The XOP seemed to hold up a little better than XLE because of this. See if this continues Monday.


There wasn’t really any single area in energy that took a bad hit, they all pretty much went down about the same. XOM seems to be a better long play than CVX. The US majors seem to be better plays than RDSA and BP. I’m still not interested in moving into any individual names. I think this is a time when it’s more productive to play the sector as a whole because there is a macro force moving the sector. If you get the macro force direction correct, you are pretty much guaranteed to make money with XLE. If you try to get fancy and pick individual names to play the macro move, you will often pick the wrong stocks and miss the move.


If I was forced to pick one area to play, I’d probably go with natural gas names EQT and COG. I like EQT as the better company, but COG is probably the better trade down at this level. The refiners will also probably become attractive soon, especially if oil price starts to fall and driving demand starts to rise. My only other single name target is WTTR. I started in on the position last week under 6 and will be adding down to 5.


Trading Plan for the Week – Primary trade this week is long XLE in the 51 area. I’ll be playing it with a fairly tight stop. Ideally, I’d like to see it dip under 50 where I’d probably move from a short term play to a longer term play. If it dropped toward 49, I’d get long with a stop at 47 for a 2-3 point risk looking for a move back to 60-62. If XLE looks like it’s going to establish demand around 50-51, I’ll take the long trade and put a 1-1.5 point stop on it for the same move back to 60-62. Those are two different plays that depend on what kind of pullback XLE makes. The SPY, IWM, TLT, UUP and KRE will all be pieces of that decision. If the overall market starts down, I’m going to be way more patient and the longer term XLE play with the 47 stop will probably be the play of choice.


I’m also watching IWM for a play around 215. If it pulls back to that January neckline, there’s going to be a larger picture decision made there. I’m not sure how it’s going to develop or what kind of trade I’m going to put on there, but that’s the location where any trade will appear. I’ll post on Twitter which trade looks best if it reaches 215.


The only other trade on the radar this week is GDX. As the dollar ripped to the upside, gold really got hit hard. I’m very interested in GDX in the 31-33 area. There’s some really big demand at 31 that should act as a concrete stop on the trade. It’s setting up for a trade where I can probably risk 2-3 for a gain of 6-7 on any move back to the 40 area. I’ll post more on Twitter as it gets closer to any entry.


Good luck this week. My only real advice is to be really patient this week and let the market tell you where the turn is. Don’t try to anticipate or outguess this market, especially up at these levels.

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