The energy sector has been dismissed over the past two years since the lofty days of $147 oil in favor of technology, consumer discretion, industrial, and financial stocks; however, with just $10 to go before hitting triple-digit prices again, the energy sector is saying “I’m back baby”. Like the title says, the daily charts on service, equipment, producers, explorers, and refiner stocks look scary; however, the weekly charts look gorgeous.
As the Federal Reserve Bank increases credit by expanding its balance sheet, there are some desirable and undesirable effects. The initial desirable effect is higher asset prices through a falling dollar. The fallen dollar then stimulates exports as our goods look cheaper overseas. The undesirable effect of a fallen dollar is increased import prices, and in this case: oil. Since the summer of 2010, oil has risen 21 percent while the U.S. dollar has fallen almost 9% percent.
With energy prices higher in the last six months, and the economy on the mends according to the Economic Cycle Research Institute’s (ECRI) Weekly Leading indicator (WLI), energy stocks look attractive. Based on Sam Stovall’s S&P Guide to Sector Rotation, I advocated last year that industrials would be top performers.
“Predicated on continued economic recovery, and given the current interest rate environment, commodities and stocks should continue to perform while bonds should underperform. Concerning stocks, I believe mid to late-cycle sectors such as industrials and energy should do well. Where else can an investor find high dividend yields and low P/E multiples but in energy stocks? Technology tends to do well at the beginning stage of a recovery (2009) and market performs in the midst of a recovery.”Economic Recovery…, January 2010
Looking at a performance chart versus the S&P 500 last year, this was the case for the Select Sector SPDR funds.
Going by the same methodology, using the sector rotation model, basic industry and energy do well as the market is recovering on towards a mature bull market (yes, this one’s been running for almost 2 straight years now) and towards the middle of an early economic recovery. We are currently still in the early economic recovery stage even though the stock market has discounted a lot of that recovery ahead of time. In this stage, consumer expectations are rising, industrial production is rising, interest rates are bottoming out, and the yield curve is normal (but steep).
Consumer Expectations (back on the rise, though the present conditions sub index has been flat since September)
Source: Dismal Scientist
Industrial Production (rising, next release 1/14/11)
Interest Rates (rising)
Yield Curve (Normal and Steep)
Source: www.stockcharts.com
Now that I’ve established the fundamental reasons for energy (falling U.S. dollar and sector rotation), let’s look at the technical reasons. On the daily charts, refiners, coal producers, exploration, producers, and natural gas producers look overbought; however, when you take a step back and look at the weekly charts, they really look quite gorgeous with new weekly highs and breakouts.
Bank Credit Analyst (BCA) recently mentioned that energy demand is on the upswing as vehicle miles driven in the U.S. is increasing. That means there will be higher demand on the finished product of refiners: gasoline. The recent crack spread (price between crude and finished petroleum products), seen below, clearly shows a breakout in the crack spread above the ratio’s recent highs in 2010. Seasonally speaking, crack spreads tend to be higher during the spring than in the fall due to retooling for heating oil in the winter and gasoline in the summer. Only in January, there’s a chance the crack spread could break the May 2010 high. Crack spreads have peaked in May, 4 of the last 5 times.
Source: Bloomberg
While some of the refiner’s daily charts look extended over the short-term, the long-term weekly charts look gorgeous. One would call them, “Picasso”, i.e. works of technical art. There aren’t many refiners to choose from, so I’ll pull up a couple well-known companies.
Another area that I see similar chart setups are in coal stocks. I’ve been a personal fan of the industry group since August 2010. The recent flooding in Australia has helped to really push the daily charts to scary levels; but stepping back, the weekly charts look gorgeous.
There’s no question with recent upgrades and Australian flooding that U.S. coal stocks are hot. The best time to have entered these companies was during the summer and fall breakouts; however, the charts are telling us that a buy on any dip is warranted if you’re seeking energy exposure to a diversified portfolio.
The energy sector has been outperforming the S&P 500 since late-September last year, as highlighted on my first chart. Performance is predicated on continued improvement at the consumer level in miles driven as well as a falling or stable U.S. dollar. Regardless of how beautiful the refiner charts look long-term, seasonality will come to play in the spring, when crack spreads typically peak and focus shifts towards gasoline from heating oil. Coal stocks have had the added push from adverse weather effects in Australia. While the flooding is preventing production, eventually the water will subside and supply will be back online. I also would expect energy to get hit hard if the U.S. dollar breaks out above the 200-day moving average, of which it’s flirting with right now due to higher European default risk. All of this is to say, energy isn’t the riskless trade, but it sure looks gorgeous long-term.
