Oil and energy stocks have been moving into a stealth bear market rally over the last two months, and that’s not a good thing for the market from a historical perspective.
Energy traders are one of the fastest groups to sniff out opportunities when oil and other energy commodities are ready to shoot higher. They've even better at identifying concerns for the market, cutting their risks and profiting from declines in the energy complex.
The last four months have seen a tectonic shift in the energy sector that goes well beyond price corrections or weakness. This is a serious long-term momentum situation.
You need to watch and trade the energy sector like this seasoned group.
Here's what you need to know.
Three sectors (ETF) of the market that are associated with the energy “trade” have quietly been sliding into a bear market trend.
The Energy Select Sector SPDR Fund (XLE), Oil & Gas Exploration & Production (XOP), and SPDR S&P Oil & Gas Equipment & Services (XES) have all been lagging the market in terms of performance, but each are now sliding into bear market trends and that has implications for where stocks may be set to head.
The thinking is simple, the market has been teetering between a soft and “hard” landing for more than a year.
Jerome Powell and the FOMC Governors seem like they’ve threaded the needle when it comes to interest rates and inflation, but energy traders are seeing it another way.
Note that I said, “energy traders”.
That’s an important part here. Historically, energy traders are some of the best out there. They’re one of the nimbler class of traders in the world. Trading futures, options on futures, equities, options on equities, etc…
This is one of the most heavily traded areas of the market. Which is why you watch it closely when it starts to make moves like I’m seeing now.
It all comes down to the economy.
It has nothing to do with “Drill Baby Drill”, oil prices are moving lower because the projections for demand are going lower.
China and other developed countries are showing the signs of economies that are teetering between growth and contraction.
Just this morning, China’s producer prices slid, causing economists to worry about deflationary conditions rooting in the world’s second largest economy.
Consumers love the thought of lower fuel prices at the pump, but many times they come with the risk of a slowing economy.
That’s what the traders are betting on.
Remember the last bear market? I’m not talking about 2020 when the pandemic hit, I’m talking about 2022 when companies like NVIDIA dropped 70% from their 2021 highs.
You know what dropped into a bear market before that carnage? That’s right, the energy market.
Traders ripped the XLE and other sectors lower ahead of the 2021 top in stocks.
It happened again in 2018 when the energy trade slipped into a stealth bear market three months ahead of the Nasdaq 100.
Before that, the 2008 bear market saw the energy sector move into a bear market at the same time as stocks. The reason for the tandem move was that the financial crisis was much faster to develop and affect all sectors of the market at the same time.
As of Friday, only one of the energy-related ETF was trading in the green from a year-to-date perspective.
Shares of the Energy Select ETF (XLE) had posted a +2.6% return for 2024 while the Oil & Gas Exploration & Production (XOP) and SPDR S&P Oil & Gas Equipment & Services (XES) are both trading in the red by -5.7% and -6.6% respectively.
Looking at the stocks that are in these ETFs, the individual trends have already slipped into bear market trends.
Breadth on the energy companies has turned notable negative.
As of today, only 10% of the 52 energy companies are trading above their respective 50-day moving averages. In comparison, 65% of the S%P 500 companies are above the same critical trendline.
Looking at the longer-term – 75% of the energy stocks are trading below their 200-day moving averages and 52% are already trading in long-term bear markets as they are below their respective 20-month moving averages.
These numbers are much worse than the data from the S&P 500, telling you that the energy sector is moving from a stealth bear market to a full-blown bear market trend.
The XLE is the one ETF to watch here.
Companies like ExxonMobil, Halliburton and Chevron along with the larger “players” in the oil and energy trade are represented well by this ETF.
The XLE’s chart shows a few signs of wear in the sector.
First is to assess your portfolio for any energy holdings and consider if you want to continue holding with risk of another 10-20% downside. Many investors will simply sidestep the downside risk by taking their profits in these situations.
There are two ways to hedge an outlook like this.
The easiest of hedges comes in the form of an ETF. The Proshares UltraShort Energy (DUG) returns 2X the inverse return of the S&P Energy Select Sector Index (IXE). That means that the DUG goes up roughly 2% for every one percent decline in the energy sector.
As always, make certain that you have the necessary options education and experience to deploy a hedging strategy in your portfolio using options.
From the long-term perspective, my choice in hedging the energy bear market trend is to use the March 21, 2025 XLE $85 puts. Those put options are trading at $430 per contract today.
Using the Black Scholes model to calculate a theoretical value for that option in the case that the XLE drops to $75 (a 14% decline from today’s price) before January 31, that option would have a value of $1,350, a 214% return to offset any declines in the XLE.
