A Warning to Energy Investors

11/07/2016 9:00 am EST

Focus: STRATEGIES

Landon Whaley

Editor, Focus Market Trader

Investors are chasing after the energy sector with reckless abandon at precisely the wrong time, explains exchange-traded fund expert Landon Whaley, editor The Whaley Report.

Investors are also running full speed after the energy sector without understand what is driving the returns, and that the risk is now entirely to the downside.

Energy stocks are highly correlated with the price of oil, which means that when oil goes higher, energy stocks follow. Crude has had a major counter-trend rally this year, gaining 38% so far, which is why energy has been the best-performing US equity sector by a wide margin.

Almost $2 billion has flowed into the Energy Select Sector SPDR ETF (XLE) since January; investors are chasing the hot performance of the energy sector even though all three of the technical aspects of my investment framework are flashing bearish signals for crude oil.

From a fundamental perspective, the picture for crude is just as bleak as it was six months ago. The world is drowning in oil supply, not to mention that the weak trajectory of global economic growth will continue to drag down the demand side of the equation.

For crude oil’s quantitative outlook, I pay particular attention to its relationship with the US Dollar, which turned positive in October. This is important, because crude oil historically has a strong negative relationship to the greenback, meaning that typically when the USD zigs, oil zags.

Based on this alone, crude is overpriced by approximately 30%. When this relationship reverts to its historic nature, crude will go from trading in the $50’s to trading with a $30-handle.

Behaviorally, it doesn’t get more bearish for oil. Hedge funds and other institutional investors are all-in on the long side of crude oil. Historic positioning on one side of a market almost always unwinds in a violent and unpredictable manner.

I’m not sure how many buyers remain, but there can’t be many. Sentiment is so aggressively bullish on oil that when I see the current fundamental and quantitative structure, I start to salivate and look for good entry points to be short black gold.

When the correction in crude oil occurs, all those investors who chased XLE’s recent performance will realize they bought high and now must sell low. I can promise you that chasing a market like this based on strong recent performance is a recipe for disaster.

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By Landon Whaley, Editor The Whaley Report

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