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Energy Sector Trading Plan for January 24-28

What a wild market. I think it’s finally starting to hit people that we are in the dangerous part of the larger cycle. But I’ll admit, energy is definitely being stubborn and trying to hang in there. Will it last? I’m not sure. I was looking for a 60-62 top, yet it managed to make it to the 65-66 level. There was more euphoria at this top than I expected. But I’m still trusting and being patient with my thesis and even though the top was the 65-66 area, the market did finally break down a little finishing the week just above that 60-62 area at 62.45. Where does it go from here, what clues are out there to help show the way, and what’s the best way to trade it?


It’s been a couple weeks since my last post, so it’s probably best to take a step back and start with the bigger picture and how it has changed. The starting point for me is smallcaps and IWM. This is the area that has been sending the loudest signal. I’ve been saying for weeks that it’s concerning that the index of 2000 of the best small domestic US businesses is rolling over. When small business starts declining, what does that say about the health of the US consumer? What does it say about the effect that higher actual and expected rates are having with regard to financing costs? If small businesses and the consumer are weakening, can oil be too far behind?


IWM had a technical breakdown this week. That 208-235 range that had been in place for the last year clearly failed. It’s a classic Wyckoff distribution pattern. Larger players ran it up in late 2020 and early 2021 and then distributed. That distribution lasted for almost nine months. In November, IWM attempted a breakout, but that ended up being a textbook upthrust pattern (and likely a place where larger players got very short). The distribution was further confirmed with the late December bounce which ended up putting the Wyckoff last point of supply (LPS) in place at 227. From there it’s been straight down, breaking through the lower boundary (ICE) with no resistance at all. The ultimate target on this breakdown is 170, which just happens to be a 50% retracement of this entire run that started at the covid lows in April 2020. It’s also the area of that 2018 IWM top and where IWM was when covid hit in early 2020, which of course created the 170 breakout point on that November 9, 2020 vaccine announcement. 170 is the perfect point of retest for the larger picture.


So now that we know the larger IWM picture, what happens in the shorter term? My best guess is that we soon see a bounce in IWM that takes it back up to test that 210-212 point where the range broke down. It’s a similar concept to a head and shoulders pattern where price breaks down below the neckline and then bounces back up to test the neckline from below. If it regains the range, then a continuation pattern is likely to evolve and we could see IWM make a run back at 225. But, if price tests from below and fails at that lower range boundary around 210-212, that’s where a lot of traders will start shorting this market and things could break down quickly toward 170. IWM is already down about 20% from the highs, so a move to 170 would make the entire correction about 30%, which could probably be considered an average and normal correction (and a healthy thing).


Now, if IWM collapses, that’s a strong signal that the rest of the market will follow in the next few weeks. I could see the SPY going 380-400 which would be a medium correction, which again is a fairly healthy thing. A correction gets rid of all the bubble talk and creates a more healthy uptrend. Don’t fear this pullback, embrace it. So if IWM and SPY pull back, what should we expect from oil and energy stocks? Can they continue to diverge and defy the overall market correction? Will they continue to lead the market or was their leading a very clear signal that this market is late in the game and possibly topping?


I posted a larger macro type rotation chart on Twitter earlier in the week. When energy, materials and staples lead, that’s often been a signal that the larger cycle may be peaking. Given last week’s SPY, QQQ and IWM action, that chart is looking fairly prescient. That chart post was met with criticism. The main complaint was that the chart hadn’t described the last couple cycles. And in fairness, it really hasn’t. But, taking a step back, you have to ask why it hasn’t described the last few market cycles. The reason is interest rates and inflation. The FED has entirely altered the traditional market cycle with their approach to QE and rates. They have had the option during the last few market tops to lower rates and pump money into the system. Do they have that choice this time? Inflation is much higher than the last few cycle tops. I don’t think the FED has the ammunition to alter the traditional macro cycle this time, therefore the posted chart could very well be accurate this go around. It would probably take a new crisis to justify more QE and lower rates at this point. We already used the initial covid scam and then the variant scam. Is it now time for the super megavariant scam? I’m just kidding, kind of. But, it’s going to take something large to get the FED to reverse course now and continue a loosening stance because inflation combined with already near zero rates has them boxed in.


One other thing that suggests that IWM and the overall market may be getting ready for a bounce in the next week or two is sentiment. Twitter is the ultimate sentiment tool. When the bears come crawling out of the woodwork and hyping up the ‘bear market’ that’s usually when things are stretched and the bounces happen. Twitter is at doomsday level right now. Everyone is claiming they are going to cash, claiming to sell the pops, and putting out crazy price targets for their five minutes of fame. There’s no way that many people being on one side can possibly be correct. Trading just isn’t that easy. I’ll fade that group every day. Will they be right one day? Possibly. But that hasn’t been the norm. Any time people start getting emotional like they are now, that’s usually a signal that the market may be getting unbalanced. However the market will seek balance again. Could this be an initiative move to a new balance area? Possibly. But right now, I’m betting we first see a responsive move back to existing balance in IWM before the real move appears.


As for the actual fundamentals of the oil market, just stop. It doesn’t matter. The recent equity sector move had nothing to do with oil fundamentals. And the next one won’t either. The move in the actual oil commodity market itself likely had nothing to do with actual supply/demand fundamentals, so why should the equities? This sector is getting pushed around as a result of what’s happening in the larger market picture. If you are trading (not investing) on fundamentals, you are constantly going to be a step behind. If you are a trader and you are quoting fundamentals, you are simply looking for a confirmation bias of your existing market position. Let it go.


Trading Plan for the Week:

So having gone through the larger market cycle picture and the possibility that this market may be at a top, where does that leave XLE and how do we trade it? The thesis of my XLE short has been based on IWM rolling over and taking the larger market with it, and it’s been correct for the most part. But, I also expect that IWM will bounce soon to test that 210-212 area. So the question now is this: Do I hold the XLE short position through that IWM bounce OR do I scratch the XLE short position near breakeven, let the IWM bounce happen and gauge the strength of that 210-212 test and then re-short XLE at a higher level? Honestly, XLE has shown great strength, and more than I expected during this IWM pullback, so what happens to XLE when IWM starts showing strength too? I think there may be enough residual strength in XLE to bounce it back to 65-67 for a double top on any IWM bounce back toward 210-212. It’s a great place to put the short on again, because let’s admit it, the 61 entry on the first half of the short position wasn’t that great.


I’m naturally a short term trader at heart, so I’m more than likely going to cover this XLE 1/2 position short on the dip early in the week if IWM shows signs of bouncing. However, if IWM continues to slide early in the week, then I’ll continue to hold the short play, looking for that IWM bounce point to possibly cover, hopefully at a profit. The next move will then be to put the XLE short trade back on at a higher level. I have absolutely zero desire to get long XLE anywhere above 55 right now. This in and out strategy on the XLE short is an extremely risky one and I wouldn’t do it if my initial entry had been better, say 64-65 or so. If you are a longer term player and not much of a short term trader, then just holding the short play through the IWM bounce is probably the safe way to go. You lose some ability to avoid a possible loss if IWM bounces and starts a new uptrend taking XLE with it, but you also take the chance of giving up the XLE short position and then watching the bottom fall out, thereby missing the reward of the short trade altogether. It’s a sticky situation. Given my smallish position, I’m willing to risk missing the trade for a much better entry price that I can size up confidently.


I’ve seen some traders hyping earnings season as a reason to get long XLE and it’s components. I don’t think this is the way to go. I think good earnings have already been priced in with this XLE run from 52 to 66. Expecting pops in these names on news that is mostly already known isn’t a good strategy. Look at what happened to SLB on Friday, excellent earnings and finished the day down 2%. As I’ve stated several times over the last six months, fundamentals just don’t matter, the macro picture and forces are in total control. I’m sure some will make the excuse that SLB would have gone up on earnings but it just got caught up in the overall market on Friday, but that’s my entire point. It doesn’t matter how good your earnings are if the larger market is positioned against you like it is right now.


One other point about market corrections, when they do happen and traders get themselves in tight spots with margin or overleverage, often times it’s the winners that get sold to cover those losses. And right now, energy is the winning sector. Don’t be surprised if this dynamic contributes to a class of stocks with good earnings getting sold off. It isn’t individual forces that matter right now, it’s the larger picture. This is especially true for the oil commodity itself. There’s some games being played there currently, mostly because of the current geopolitical situation. It’s an area that traders are pushing easily, almost to the point of a squeeze and euphoria. Who’s going to short oil with this geopolitical environment? Sometimes when every other sector of the market is bad, good traders will find an area and congregate there which makes that area stronger than it would normally be. That’s what I think we’re seeing in USO right now. Throw in a sketchy geopolitical environment and it makes oil really attractive for short term traders. But when the market settles and the geopolitical storm passes, those short term traders can quickly decide to move on leaving pure destruction in their wake.


We’ve also got a FED meeting this week. That’s another reason I may cover this XLE short and try to put it back on higher. Given the market decline since the start of the year, does anyone really think the FED is going to cause further damage? If anything, they may go out of their way to calm the market and throw them a bone to get things moving back up again. If that happens, being short oil (or other commodities) is NOT the place you want to be. I could see a positive FED result leading to an easy test of the highs for XLE. Again, I think I’m right in my larger picture thesis, but my initial play in the shorter term just hasn’t been that accurate, I was too early. I’m leaning toward exiting and giving the play another try at a higher level. I can accept missing the move, because with a position of 61 I don’t think there’s that much profit that I’d be giving up if I miss it. I also think there would be ample opportunity to at least put the trade back on 59-60 if I see that exiting was the wrong choice. That’s sacrificing a dollar or so, which is probably well worth the gain of putting the trade back on 5-6+ dollars higher. Trading is a dynamic game, things change, so you have to change your plans with it.


If things start strong on Monday and IWM, SPY and XLE start moving straight up, then I’ll just hold the short play. I’ve still got half to put on, so putting that half on up in the 66-67 area takes the average trade price to the 64 area, which I can live with. And if XLE just keeps going up to the 69-70, then I don’t have to add anything if I don’t want to. The greatest trading plans give you multiple options to move with the market without being locked in.


I’m not really watching any individual energy names right now. My shorter term trading focus has been on trading some other areas of the market, mainly smaller cap names. With energy, I’m content to try and capture the overall sector trend with XLE. I’ll get interested in individual names again when the time comes to take the XLE short play off, hopefully at much lower levels. I have no desire to get caught in single stock risk right now in energy.


One other energy point, I really wish I had given the XOP vs XLE more thought when I put on the initial short trade plan. I should have realized that XOP correlated more closely with IWM than XLE does. However, I had been trading XLE for months and had been ignoring XOP. I simply had a better feel for XLE and stuck with it. XOP never got the breakout and put in an almost perfect double top. If I exit the XLE short, I may give some serious thought to putting a small portion of the money in a short XOP play, in addition to XLE. It’s got a very clear level around 112-113 to play off of, just as XLE has a clear level around 65-66. The key now though is that XLE is clearly the more overextended of the two and therefore the better short risk/reward. Also, if this IWM breakdown leads to a SPY breakdown, then XLE is the better correlated approach to tracking the SPY pullback. Just some thoughts for you guys who trade XOP instead of XLE.


Outside of energy, I’ve been finding some success in very small cap IPO plays. With this larger market pullback, especially in IWM small/micro caps, there’s some incredible swing type trades out there right now in the 1-6 week range. I’ve still got UNCY, BJDX and DRMA. Others on the watchlist are getting close to buy points: BEAT, CING, NRSN, NEXI, INKT, RCRT, VQS, SQL, TIVC, MRAI, HILS, BLBX, NXGL, CYN, CGTX, FEMY, GANX, LUCD, INAB, MIRO. This type of trading is very risky, but it’s basically where I learned how to trade many years ago. Sometimes the weirdest areas can provide the best opportunities. I’ve never been too proud to drop down and slum in the microcaps when the opportunity presents itself LOL.


I’m also seeing a lot of traders hyping GLD and GDX. I’m just not sure about that one. GDX is one of my favorite things to trade, but there’s just no existing trend there and no definable future trend outlook there right now. If the FED follows through with their higher rate threats, then that should strengthen the dollar and put a cap on GLD (as well as oil, copper, etc). Gold just seems completely random right now and there’s really no decent risk/reward. At some point, interest rates (or at least the threat of such) will curb inflation. I don’t know how far we are from that point, but if we reach it, that puts a top in commodities and banks since inflation and rate expectations to cure that inflation seems to be the source of their uptrends.


So that’s my larger market view and where the XLE short play stands now. Things could change quickly. I’ve been scarce on Twitter lately and will probably try to avoid it for awhile. I go through this love/hate relationship with Twitter. You guys can always DM me if you have questions or comments. Good luck this week and protect yourselves. Now it’s time for some wine, music and a warm fire.


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