Yesterday, I discussed the recent slide in oil prices wherein I stated:
“For investors long ‘energy’ at the current time, oil prices are indeed extremely oversold and are due for a bounce. That ‘bounce’ should likely be used to substantially reduce energy positions in the short term as an increasing amount of data suggests oil prices could go lower.”
Today, I want to specifically address the “technical” backdrop for energy related investments. Specifically, I will use the NYSE Energy Index (NYEI) as a proxy for the overall investment space as it contains a broad spectrum of energy space participants from refiners to drillers. Also, I will use weekly and monthly data, rather than daily, to smooth out the “noise” of short-term market gyrations.
Note: As a portfolio manager, I am invested for long-term returns but remain focused on short-to-intermediate time frames for risk management and capital preservation. In other words, I want to be invested when markets are rising, but avoid the bulk of the major market declines along the way. Spending the majority of your investment time horizon making up previous losses is not an investment strategy to live by. Therefore, while fundamentals are critical in understanding “what” to invest in, it is also just as important to know “when” to make it and when to take profits in it which are critical to compounding long-term value.
This is the focus I want to take today with respect to energy-related investments. While oil prices have indeed had a sharp decline in recent weeks, does that mean that it is now time to “buy” for a long-term investment horizon?
There are several ways of potentially answering that question. First, if we look at the NYEI as compared to West Texas Intermediate Crude we find, not surprisingly, a high correlation between the energy companies and the underlying commodity. The current price correction is well within the norms of a “Fibonacci Retracement” having only slightly surpassed at 38.2% retracement of the advance. With the decline in oil prices far surpassing that of the NYEI, it is probable that the correction in energy-related investments is not complete as of yet. There is strong historical support at the 50% and 61.8% retracement levels.
However, before we get there, it is highly probable that we will see a rather sizable “dead cat” bounce first. Following the 2008 decline, the NYEI experienced a rather substantial bounce that allowed investors an opportunity to rebalance and clean up portfolios before the next decline set up a buying opportunity for a strong run higher. As you will notice, each time there is a sharp correction in the NYEI, the subsequent bounce has been an opportunity to sell positiions that are underperforming, experiencing credit related issues or were just poor investments to begin with.Strongly rising markets mask many investment errors made by investors that are quickly, and brutally, revealed during market declines. These bounces give investors opportunities to clear those mistakes.
The subsequent decline provided an ideal opportunity to reallocate portfolios to better quality and performing issues within the portfolio. The current sell-off is likely the first leg of a similar pattern that investors should use to clean up portfolios in energy related investments.
There is one other interesting point to make about the recent decline in the NYEI and oil prices. As shown below, the surges in oil prices and energy related investments have clearly been impacted by the Federal Reserve’s monetary intervention programs. As banks were flooded with cheap liquidity, that liquidity was leveraged through a “carry trade” and then reinvested into areas with the most “bang for the buck.” Energy related commodities have been a great vehicle for that trade.
However, during periods where the Fed has been absent, or at least not expanding their balance sheet (blue highlight), the NYEI and oil prices have either stagnated or declined. Notice that the current decline and “sell signal” occured as the last vestiges of liquidity were withdrawn by the Federal Reserve.
The red dashed lines denote the “buy/sell” signals issued by a simple moving average crossover. Given the absence of Federal Reserve interventions, it is likely that the current price decline in the NYEI could have more room to go on the downside. However, as I denoted in the previous two charts, a “sucker’s rally” will most likely occur first that will excite investors, and the media, into thinking the current oil price debacle is over. That assumption will likely be wrong as the bullish trend that begin in 2009 is now over.
Clearing Up A Couple Of Myths
It is important to remember that while the mainstream media keeps touting the “benefit to the consumer” from a decline in energy prices, it is not a tangible one. Think about it this way. When I receive a “true” tax credit from filing my taxes, I receive an actual check from the Treasury Department. For many individuals, they look forward to their “refund” to fund purchases of a television or take a family trip. However, when an individual fills up their automobile, there is not an extra $10 bill that shows up in their wallet, therefore, the incentive to spend really is not recognized and the “savings” get washed within already tight consumer budgets.
As I showed recently, lower gasoline prices do not equate to higher consumption.
Also, there is little evidence that lower energy prices equates to higher levels of economic growth. In fact, as shown below, sharp declines in energy prices has actually been coincident with lower economic growth rates.
Making The Point
Unless you are a very adept short-term trader, now is most likely NOT the time to be making big bets on energy. There is little doubt that the majority of mainstream economists are going to be deeply disappointed by domestic economic growth over the next year. The deflationary spiral in the Eurozone, economic sluggishness in Japan, Russia, China and the emerging markets will all wash back onto domestic shores suppressing both the economy and corporate profits. That combination does not bode well for another robust year of stock market gains.
While the NYEI is deeply oversold at the moment, and due for a rather substantial bounce as I stated above, that bounce should be used to carefully evaluate portfolios and reduce, or eliminate, holdings that are fundamentally poor to reduce overall portfolio risk.
Be assured that there will be a time to be aggressive buyers in the energy space once again, however, that time is likely not now.
Images: Flickr (licence attribution)
About The Author
Lance Roberts – Host of StreetTalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.