Is the Energy Sector Signaling a Boom or Doom?

2018 will go down as one of the strangest years for the stock market. At the beginning of 2018 most analysts and financial professionals were hoping for a fifty-percent increase in stock prices for the year. By the end of 2018 stocks posted a negative return for the year, while cash and U.S. Treasury bonds were the top two performing asset classes. For those who had the foresight to hold cash and Treasuries in their portfolios against the better judgment of nearly every financial professional, you have my sincerest respect and admiration.

As I was preparing for my Weekly Economic Update this past Friday my attention was focused on the largest energy Exchange Traded Fund (EFT). I noticed something unusual while updating my proprietary momentum charts—the price of the largest energy ETF (symbol XLE) was leading momentum down. Normally momentum leads price, so it was time for an investigation because price charts always tell us part of the story.

Last week, I mentioned a potential opportunity in the oil and gas exploration sector for 2019 because the price is hovering just over its twenty-year low. As stock prices head into a Bear market, which is anytime stock prices are 20% or lower from their highs, and the economy slows down, I feel it is prudent to look for sectors that are already low as it reduces potential downside risks of buying into a Bear market rally.

As I also mentioned last week, the first leg down in a Bear market is approximately three months. This is followed by a three-month rally. After the three-month rally, if stocks continue rising, then we are still in a Bull market but if they fall, then the Bear market is on. However, the Fed’s tightening monetary policy by raising the Federal Funds rate and unwinding their balance sheet might alter these historical three-month cycles.

While the Fed has attempted to notify investors that tighter monetary conditions will lead to lower asset prices, it hasn’t stopped investors from buying stocks—even when the stock market fell 5%, 10%, 15%, and 20%. Bullish sentiment remains unusually high, even as stock prices fall. If investors like buying stocks when they are down twenty percent, then they should really be excited about buying stocks when they are down another twenty-five percent.

Based on the relationship between the monetary base, which is all the cash in circulation and in bank accounts, plus the total amount in bank reserves and the stock market, stock prices need to fall another twenty-five percent from where they are today before they are fairly valued. Not all experts agree with this relationship. Last Friday Vinay Pande, the head of trading strategies for the wealth management group at UBS Group AG, who was on CNBC’s Squawk Box, did not agree with the hosts that the Fed’s QE programs propped up the stock market.

Perhaps Pande has not seen the charts I have shared over the past couple weeks showing the relationship between the major stock indices and the Fed’s balance sheet, which I’ll be happy to send him if he should ask for them. With the Fed in full tightening mode and the fiscal stimulus from the tax cuts wearing off, stock prices have been steadily falling with energy stocks in a freefall.

When I pulled the chart for XLE, the largest energy ETF, I think it is in the midst of a very long and large topping pattern, based on classical charting principles. For reference, XLE has 253 million shares outstanding, of which 15 million shares or more trade hands every day. The largest three holdings of XLE are Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP), in that order.

XLE is currently trading at the same price it did in October 2008, right before the broad equity market plummeted going into the last recession. With XLE’s three largest holdings also trading around the same price level as they did prior to the Great Financial Crisis, the energy sector is either suggesting a bottom is forming or the floor is about to fall out.

To determine if the energy sector is leading the decline or bottoming ahead of a rally, the first place to start is with the Federal Reserve. The Fed is entering the fourth year of their monetary-tightening cycle which, on average, last around two years before they blow up the economy. No economic expansion or Bull market has started or continued three years into a monetary-tightening cycle. The purpose of a monetary-tightening cycle is to slow down the rate of economic growth, which should reduce the demand for oil.

The price of oil, or any commodity, has much to do with supply and demand dynamics. Demand for oil appears to be slowing as the growth rate of the global economy is slowing. From a supply standpoint, based on my resources and other experts, above ground, below ground and floating storage of crude oil are rather full. With global oil producers pumping near-record levels of crude, weaker demand should put downward pressure on prices. When oil prices fell -40% between October and December 2018, it validated the supply and demand imbalance.

Oil prices are also sensitive to expansion in the monetary base which causes oil prices to rise in an attempt to soak up some of the newly printed currency entering the economy. Initially, oil responded to the Fed’s expansion of the monetary base, but now oil prices are leading the Fed’s planned contraction of the monetary base. From a monetary perspective, the recent drop in oil prices makes sense. With the Fed planning to further contract the monetary base next year, the bottom for oil might not happen until the Fed pauses.

Insider sales from corporate executives, who typically hold large blocks of shares in their respective corporations and have access to high-level information regarding their specific sector, are a good proxy for the direction of share prices. When insiders are buying, share prices should rise and when insiders are selling, expect share prices to fall. Anytime a corporate executive makes a transaction, they must make their intention public prior to engaging in the transaction. Based on public records, insiders have been unloading huge blocks of their shares.

Based on classical charting principles, the price chart of XLE is showing a large head-and-shoulders reversal pattern over the past ten years. When looking at a weekly chart of XLE, draw a horizontal line at $55 per share, which is the “neckline” of the head-and-shoulders top. The largest volume is around the “left” shoulder, between February and October 2011, with the next largest amount of volume showing just after the “head” formed in June 2014.

The price of XLE came close to breaking the neckline in February 2016, but large buyers stepped in to form the “right shoulder” over the following two years. Should prices break the “neckline” at $55 per share, prices should continue to head much lower. Share prices would then likely find support, or buyers, near $40 per share, representing an approximate -25% decline in the share price. Should prices hold at $55, but I don’t believe they will, then perhaps the economic expansion will last a little longer.

Large multi-year topping patterns are unusual, but due to the large number of shares issued by energy companies, it takes a long time for large shareholders to liquidate their portfolios. As the Fed monetary-tightening cycle extends, liquidity (the number of available buyers) declines. With fewer buyers available, large shareholders need to have liquidated their holdings by now. The chart pattern confirms that the large shareholders have liquidated, as the trading volume at $55 per share is low. When trading volume is weak on the “right shoulder” of the chart pattern, it validates the entire structure.

With the Fed tightening, the large shareholders out, and supply at high levels, the energy sector is validating a further decline in global growth. The only group who hasn’t sold are retail investors, who remain Bullish about stock prices and the economy. It won’t be until the public sells before prices bottom. Since most retail investors were defensively invested prior to the Presidential election, it wasn’t until after the Presidential election that most retail investors bought stocks.

Even the largest banks are signaling that an economic slowdown is coming as they increase their bond holdings. Banks make money by lending, and when the economy is expanding, banks sell their bond holdings to raise cash in order to lend to credit-worthy borrowers, including energy companies.

In November 2018, the large banks increased their holdings of U.S. Treasury bonds by $28.9 billion, their Mortgage-Backed Securities (MBS) by $15.2 billion and their non-MBS bonds by $13.7 billion, for a total of $57.8 billion. In the first three weeks of December, the large banks increased their holdings of U.S. Treasury bonds by $72.3 billion, their MBS by $42.3 billion and their non-MBS bonds by $30 billion, for a total of $144.6 billion. Cleary the large banks are concerned.

As stock prices succumb to the weight of the Fed’s contraction in the monetary base, it won’t be until early- to mid-January, when annual statements arrive in mailboxes, before some investors start to sell. When retail investors begin to sell, they will find the stock market is rather illiquid, which will cause stock prices to fall further than and faster than expected.

Liquidity is a best expressed as the buying power of the market. There are still buyers out there, but the amount of shares they are demanding is rapidly shrinking. Large investors who could normally dump huge blocks in a day are now forced to split their sell orders up over multiple days to avoid tanking stock prices. It is the lack of liquidity that is causing the recent large daily swings, both up and down, in stock prices.

The lack in liquidity has been created by the Fed tightening monetary policy, which has reduced the amount of currency in the financial system and large government deficits, which requires a large amount of money to be borrowed from the public. The combination of the two, in addition to selling, which begets more selling, causes stock prices to fall. There are two people who can temporarily stop this – Federal Reserve Chairman Powell and President Trump.

At the end of January, the Federal Open Market Committee (FOMC) will meet to discuss monetary policy. By pausing or delaying their next rate hike, the Fed could signal to investors that it is safe to return to the equity markets. President Trump, who is determined to increase the tariffs against China on March 1st, could negotiate a partial trade deal that would also calm investors. A pause by the Fed or a trade agreement with China won’t change the long monetary lags that are starting to affect the economy, but a bit of good news could be just enough to lure investors back into stocks.

The “Smart Money” tries to unload as many of their shares onto the public as close to the market peak as possible, so the reason we often see one last rally prior to the stock market plummeting is for the “Smart Money” to sell their last remaining shares. The public is often eager to jump on this opportunity as they find the potential for large, fast rallies nearly irresistible. The variables, however, will be the monetary lags and the fourth quarter economic data, which I don’t think will be as rosy as everyone is hoping.

The third-quarter GDP numbers showed heavy inventory building and, if corporations didn’t move their inventories, earnings growth should quickly decelerate. As far as the monetary lag goes, I think we are about fourteen months into it, which means the economy is about to feel the effects of the first round of the Fed’s balance sheet unwind from October 2017. I recently read a brief from a financial expert who thought the monetary lag is already eighteen months. If she is correct, the economy is now digesting the June 2017 rate hike and there is a three-month gap before the October 2017 balance sheet unwind hits.

Should there be a window to buy in, it won’t come until the public sells, which should be evident by plunging prices and high trading volumes. Short-term market bottoms are never formed in a day. It is a process that can last up to several weeks. To minimize downside risk, the key is to look for deeply undervalued sectors, such as the energy sector, where it is already inexpensive relative to other sectors.

Most investors will not be able to take advantage of a short-term bottom if it occurs, because they will be too busy licking their wounds from selling. Only those with cash or highly liquid securities, such as U.S. Treasury bonds, will be able to buy without taking a hit from selling other securities.

Keep in mind, historically these Bear market rallies are no longer than three months in duration and there’s no guarantee if we do see a Bear market rally that it will last even that long. The opportunity to sell will come when the public feels confident to buy back in. I’m hoping early 2019 gives us a great opportunity to buy in for a short-term play. As one former hedge-fund trader recently wrote, a Bear market rally in the first quarter could make the year for those who are positioned to take advantage of it. Good news!

Happy New Year!

New Year’s Look at the Markets (01/02/19 – 15 min)

Weekly Economic Update (01/04/18 – 31 min)