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Weekly Energy Review: Buyable Dip or Deadly Trap?

I’ve posted my bearish thoughts over the last couple of weeks and the energy sector has finally started to price in some of those items. XLE has dropped from the double top at 59.41 all the way down to close Friday at 54.83 on large volume of 46 million shares. That’s about an 8% drop. My initial target on the short position downside continues to be 53. If XLE makes a move toward that 53 target, that would be about an 11% pullback, at which point the question becomes: Is this is a buyable dip or a deadly trap?


It’s my opinion that any bounce off this 53-54.83 area is a trap. If XLE does find support somewhere between Friday’s close and 53, there could be a bounce back toward 57, but I think supply just pours in and overwhelms the few remaining buyers there, which should send price right back down to the early week lows, and possibly lower. If 53 doesn’t hold, there is a small level around 50, but the next major level doesn’t appear until 46-47. If price reaches the 47 level, that would be about a 20% pullback off the highs, which I’d probably cover the short play completely and get long in a big way.


There’s a lot of technical stuff going on in the XLE chart. In the short term, price made this latest blowoff type move starting around October 1 at 47. Price moved to 59.41 fairly quickly where it put in an almost perfect double top at 59.41 on October 26 and 59.40 nine trading days later on November 8. Patterns don’t get much more obvious and perfect than that. If the bottom of the pattern is 47 and the top is 59.41, a 50% retracement would put price right at 53, which is my initial downside target. I don’t know what happens at 53, but whatever does happen there will tell a lot about the strength of the energy sector. If price cuts through 53 easily, I’d guess that the next stop is 50. If demand shows up at 53 and price bounces strongly, I’d guess it might bounce back to 57 where another evaluation of strength/weakness would have to be made. That’s really too far into the future to make any reasonable estimation.


In the longer term technical picture, this inflation trade of smallcaps, banks and energy started back in early November 2020. XLE moved from 27 to 54.91, which is nearly 100%+. The 38.1% Fibonacci retracement level on that move would put price at 47, which is a major demand level on the chart. That’s where large demand should show and I think that’s probably the low for this current pullback. A 50% retracement of this entire move off the November 2020 vaccine re-opening lows would put this pullback at 43. I have no idea what happens at 47 or 43, that’s just too far in the future, but those are the points to watch.


While the bears have certainly taken control of the sector, I still think it’s just a bit early to take any victory lap on the short play. This market is crazy right now and I wouldn’t be surprised to see the bulls make another stand. Much of that stand will have to do with the overall market and SPY/QQQ. It feels like the overall market is in the process of making a blowoff top with more upside possible on a buying climax. But one thing to notice about XLE is that these very high volume down days like Friday have been followed by bounces over the last 6 months. May 11, June 18, July 19, August 19 and October 6 all had the highest volume days in the last six months and every time that volume put in a bottom and price bounced off those days. It will be interesting to see if this pattern of bounces off of high volume down days continues on Monday or if the pattern changes with price following through to the downside with no bounce. If that pattern of bounces after high volume selling no longer holds, that would definitely be a signal that underlying support may no longer be there in the bigger picture.


I’ve posted my bearish thesis, and this week has more negatives to add to that long list. There have been new lockdowns in some parts of the world and that’s not going to help the sentiment for oil. If these lockdowns spread, that’s only going to cause sentiment to get worse. Also, the US hasn’t even hit cold and flu (and Covid) season yet. I think when the winter cold and flu season hits, government officials are going to overreact again and start preaching more gloom and doom, whether that be more lockdowns, travel restrictions, mandates or business closures. The oil market priced in that Covid was basically over, but I don’t think it is. While the actual health threat probably isn’t a big deal, the optics of the government’s overreaction to it will be. And what better way to keep oil demand and prices down than to initiate more lockdowns or travel restrictions? This isn’t about health anymore, it’s about the economy, inflation and a possible resulting recession which the US can’t afford.


Energy investors have put themselves in a position where they are playing adverse to the larger government, and that’s just never been a good bet. The Biden administration has recently shown that it has no clue on oil and how to control it. They will continue to grasp at straws on how to attack prices. I think this recent price action in XLE is a signal that institutions now realize that and really don’t want to put money at risk against the whims of government action. I’m not saying that what the government is doing now is going to work in the long run, because it isn’t, but they can definitely cause a lot of oil price (and equity) destruction over the next six months.  If you are a longer term investor (I’m not) then this pullback toward 47 might be a gift. But the risk on that longer term investment is that all this interference causes oil prices to spike in late 2022-23, which pushes the US economy over the edge into a recession, as energy is a huge portion of the inflation problem.


All these factors including increasing dividends into a higher interest rate environment, increasing buybacks at these peak prices, eliminating hedges with oil at $85, limited ability to plan due to OPEC and US government action, coordinated SPR releases, a strengthening dollar, increasing capex near the oil price cycle top, more covid doom to come and increasing inflation just make this sector unattractive. That doesn’t even take into account an overall market correction, a forced FED tightening or the beginning of a recession as inflation gets out of control. And then there are the black swans that we don’t even know about. Our economy is likely one swan away from collapsing because of the recent actions taken during the covid pandemic. That’s just so much to fight against. At this point, I can’t really think of any short term positives. The technical picture is even worse. Are institutions really going to push all their chips in after a 100% sector run over the last year? Or did they just run the price up over the last month and dump all over retail who is now left holding the bag?


Overall Market Technical Thoughts:

SPY – 470 is the obvious level to watch. It’s setting up a little like that double top that formed in XLE. I’ve been waiting for a buying climax in SPY and QQQ and this chart is possibly setting up for that play. If price breaks 470, that could set off a Christmas rally run toward 500, where the buying climax likely puts in a top that lasts for awhile. There’s a good chance that this Christmas rally might be the last gasp for this bull run. As the calendar changes to 2022, things could change quickly as many players reset their portfolios and risk. Watch any break below 462, that would also suggest the top might be in for the short term.


IWM – This is the real concern for energy players. The breakout from the nearly year long range between 210 and 233 is trying to fail. 234.53 was the point to watch and price closed below it on Friday at 232.92. Look for another test of 234.53. If it fails there again, price could make a run well back into that 210-233 range. If price does get back into that range, there’s even the danger that it could head right for the lower boundary at 210. If 210 breaks and builds under, this market is in serious trouble. On the brighter side though, if price does test that 210-233 range, and price holds, it could set up a nice leg up toward 250-260. It really depends on the action of this retest of the recent IWM breakout.


UUP, EURO, CAD – The dollar is strengthening and that’s not a good thing for the USO. The USD/CAD pair has run from 1.2300 to 1.2650 over the last couple weeks and could run toward the peak of 1.29 that has been tested a few times during 2021. If the USD/CAD somehow breaks above that 1.29 level, that likely indicates that oil is headed for a big collapse. I posted a EUR/USD chart a couple weeks ago showing the head and shoulders breakdown and that pattern continues to develop with the pair closing Friday at its lowest point since summer of 2020, which just happens to be when the oil run started. The strengthening dollar itself isn’t really the cause, it simply reflects the underlying conditions that are causing the headwinds for oil. If the dollar continues to strengthen, that indicates that the headwinds for oil continue to get stronger.


GLD/GDX – I posted the GDX chart a couple weeks ago for a long play at 31 and that play did happen (I missed it), but it looks like things have stalled out for gold. It was actually surprising to me that gold did as well as it did in a rising dollar environment, but it looks like reality may now be setting in as GLD (and GDX) took a sizable dive on Friday. See if this continues this week. I’ll still be watching the 31 level this week, but honestly I’m not sure I want any part of a long play there if it comes down again. A top has clearly been put in at 35 and if inflation continues and the FED is forced to tighten and the dollar continues to climb, the GDX could break well below 31 for a much better play near those late September lows around 28-29. I think there could be a long play there, but it’s going to take some patience.


Trading Plan for the Week:  So enough gloom and doom bearishness, I know you guys are probably getting sick of it LOL. I’ve built my short position and this week I’ll get some good road signs to gauge the strength of that play. The first point of interest will be Friday’s low. I’m expecting a gap down on the open Monday. If price gaps down and then reclaims Friday’s low, that’s probably a sign that we are in for an early week bounce back up toward 57. I’ll hold the short position through that bounce and likely add to it as price makes a decision at 57. If price does test 57 and fails with supply pouring in, then I’ll add and look for price to come back and test the early week lows for more downside.


As a bear, what I’d really like to see on Monday is a gap up and failure. If XLE fails after an early week run up, that probably means that the high for the week is in and price then explores the low as we move into Wednesday and then early the following week. If price makes a run at 53, I’ll likely start taking some of the short play off and lock in some profits and then wait for a bounce to once again build the short position back to full size. If a trend develops, that becomes a pretty good environment to trade around a core position.


One danger this week though is that it’s a short Thanksgiving week. The market may be thin with many taking off and the moves could be exaggerated. It’s a situation where you definitely have to keep some tight stops if you are doing any intraday trading, because things can get out of hand really quickly. I’m content to hold the short swing position for now and probably won’t do much scalping this week.


One other warning, please take all these energy gurus on Twitter with a grain of salt. They are leading so many new energy traders to a complete slaughter. My favorite Canadian guru is still calling the XLE a “generational buying opportunity” after a 100% run to 59.41. These guys talk their book and they need a sucker to sell to and dump on at these peak prices. Don’t be that guy. I’m seeing the same old “but the fundamentals haven’t changed” posts that I saw last time the XLE topped out around 56 this summer. The fundamentals DO NOT MATTER in this current environment, especially in the short term. Please be careful with these kinds of people on Twitter. Do your own research, trust your own plan and opinion. Don’t get caught in the herd. At the very least, find someone with an opposite opinion and really ask yourself which person is correct. I see so many people get destroyed because of a confirmation bias. They only select the information that supports their long position and they ignore everything else. Many times that causes them to ignore the most important information. This game is brutal, protect yourself out there.


Non-energy Trading Ideas – With the energy market stuck in that 57-59.41 range for a few weeks, I stepped back into some old trading methods in the microcap market. The action there is incredible, but it also indicates that speculation in this market is reaching dangerous levels. But, sometimes the situation is so attractive that you have to go where the money is. Keep an eye on IWM and if it starts back upward after testing the range underneath, these microcaps could explode into Christmas.  I’ve got UNCY, RCRT and BFRI as lotto plays right now. DRCR, PPTA and CLIR were all nice gainers over the last few weeks. My favorite smallcap watch right now is WTTR. I’ve played this one for a few nice runs this year and it may be setting up for another opportunity in the 4-5 range.


I’ve got a few other microcaps on the watchlist that all fall under a consistent theme. These are very specific types of plays and very risky, so position sizing is of priority importance. Microcap list:  BJDX, KTTA, MRAI, SQL, VQS, CNTX, EZFL, PTIX, BRTX and BRDS.


That’s all I got for this week, strictly watching the short XLE play on a short holiday week in possibly thin action. Headed out for a couple bottles of wine today and some live music. Only thing missing is the warm sunshine. Sitting inside just isn’t the same, but I’ll make do. Good luck and have a great week.


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