Slowing Inflation, Crashing Crude Set Up Great Short Trade in XOP

06/22/2017 2:51 am EST

Focus: STOCKS

Landon Whaley

Editor, Focus Market Trader

Today’s trade idea from Landon Whaley: You can initiate new short trades in the SPDR S&P Oil and Gas Exploration ETF (XOP) on rallies to $33.11 or higher. Do not chase this market lower, because markets don’t go straight up or straight down.  

In April, I published a commentary in which I channeled my inner Miss Cleo and foretold the coming rollover in U.S. inflation. Since that commentary, the annual pace of headline CPI has slowed for three consecutive months. The playbook for a slowing inflation environment is simple: you avoid (or opportunistically short) the energy sector.

Despite the data being obvious and the playbook being straightforward, most investors aren’t yet hip to what the inflation rollover means for asset class performance. Their oversight is our opportunity.

Just the Facts, Ma’am
Last week we received May’s inflation numbers, which showed the slowing of headline CPI for the third successive month. The media declared this was the third time CPI had “missed” expectations, that it shifts the Fed’s entire policy trajectory and that no one saw this coming.

As for the first part, there is nothing I disdain more than economists’ consensus forecasts. What could possibly go wrong when 16 people forecast something as complex as the global economy and then take an average of their guesstimates? Yet, Wall Street and most investors judge the merits of an economic data point entirely on whether it “met, missed or exceeded” expectations. I can promise you that there is no more fruitless evaluation of economic data.

As for how slowing inflation impacts the Fed’s plan, a whole lot can happen between now and the next “live” Fed meeting. It’s a waste of time trying to predict what the Fed may do months from now based on inflation data that is already a month old.

As for no one seeing slowing inflation coming, I know at least one guy who did.

Mathnasium
No, I don’t have a crystal ball, but back in April, the inflation math was unambiguous. When crude oil doubles in price, as it did at the beginning of 2016, it’s going to have a positive influence on inflation numbers. Likewise, when oil trades sideways, as it did from October 2016 until late April 2017, that will also impact the pace of inflation, but to the downside.

The data indicated the most likely direction for inflation in the coming months was lower. What I didn’t anticipate back in April was that crude would stop trading sideways and enter crash mode. Crude oil peaked on April 14 and has precipitously declined 17% in the last 10 weeks. This crash in crude will absolutely weigh heavily on headline CPI in the coming months.

This combo platter of slowing inflation and crashing crude is wreaking havoc on the energy sector, but for reasons beyond my comprehension, investors are ignoring what the data and the markets are telling them in real-time.

Dumb and Dumber
So far this year, investors have plowed money into a variety of energy exchange-traded funds. Specifically, they’ve invested $348MM into the SPDR S&P Oil and Gas Exploration ETF (XOP), $207MM into the VanEck Vectors Oil Services ETF (OIH) and $980MM into the Energy Select Sector SPDR ETF (XLE).

Now, I could understand taking a shot on these markets as inflation continued to accelerate in January and February. But investors are plowing money into these ETFs right now, while inflation is actively slowing!

Since I published my commentary on April 10, investors have added $276MM to XOP, $92MM to OIH and $133MM to XLE!

There is no nice way to put this. These people are getting crushed. During this period of ETF inflows, all three ETFs have declined: XOP is down 19%, OIH is down 23%, and XLE is down 9%.

Talk about doing the exact wrong thing at the exact wrong time. Throwing capital at markets that are in the process of crashing is how portfolios get wrecked.

That said, one person’s Titanic is another person’s Whydah Gally.

“X” Marks the Short
The market I most like to use to take advantage of the continued downside in the U.S. energy sector is the SPDR S&P Oil and Gas Exploration ETF (XOP).

The Fundamental Gravity for the U.S. energy sector doesn’t get much more bearish than it is currently, with inflation rolling over.

Quantitatively, price is down on accelerating volume, which indicates conviction in the down move. Couple this fact with a volatility increase of 32% since the beginning of the year and a nearly perfect positive relationship with the direction of crude prices, and you have a perfect bearish storm for XOP.

Behaviorally, as I said earlier, investors have been increasing their stake in XOP all year, and even more so in the last couple of months, despite the bearish tilt of both the Fundamental and Quantitative Gravities.

The Trade Idea
You can initiate new short trades in the SPDR S&P Oil and Gas Exploration ETF (XOP) on rallies to $33.11 or higher.

I can’t say this strongly enough: do not chase this market lower, because markets don’t go straight up or straight down.

XOP has been in a downtrend since peaking in mid-December, and while I believe there is another 10-15% downside, it’s not a question of “if” this market will experience a countertrend rally, but simply “when” the rally will occur.

The worst thing you can do is initiate short trades while a stock is falling. If you do, when that fierce countertrend rally occurs—and these are often quick and violent—the damage to your portfolio will have you looking for the nearest door to float on.

Remember, we don’t tug on Superman’s cape, we don’t pull at the mask of that old Lone Ranger and we don’t chase markets.

Once you’ve initiated a new short trade in XOP, you can use a risk price between $36.30 and $37.83, depending on how much room you want to give this trade to move around. If the trade moves in your favor, you should book profits if XOP falls down to the $27.63 to $25.45 area.

The Bottom Line

Economic and financial market data may be less entertaining than media narrative, friends at cocktail parties with stock tips and nut jobs on TV with more sound effects than financial market acumen. But if you want entertainment, may I recommend a 22-hour flight to Macau and a night of sic bo or fan-tan?

If you want to earn superior, risk-adjusted returns, then you must stay data dependent, process driven and risk conscious. The data indicates inflation will continue to slow in the months ahead. The process says avoid (or short) anything energy related. And risk consciousness says you don’t add money to markets that are in crash mode.

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