Safely Pick a Bottom in Energy Stocks (XLE, XLU)

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Energy stocks have been under significant pressure — enough so that they’re the worst S&P 500 sector during the first 300 days of 2014. Declining oil prices have created headwinds for energy stocks, which makes picking a bottom a tricky endeavor.

One way to trade the energy space is to place a pair trade against the utility stocks, and given the ratio between the utes and energy stocks, a pair trade is a very attractive bet.

Since peaking after the first half of 2014, energy stocks — as measured by the Energy SPDR (XLE) — have tumbled 12.43% at the same time that a majority of the S&P 500’s sectors have shown positive performance. While healthcare — Health Care SPDR (XLV) — has been the best performer, utilities — Utility SPDR (XLU) — also have notched robust gains.

S&P 500 sector performance

One way to minimize the risk of purchasing energy stocks is to change the trade to pair trade. A pair trade is a market-neutral strategy — you are more interested in the performance of energy stocks relative to the utility sector, as opposed to the outright direction of energy stocks.

For example, if you purchased $1,000 of the XLE and simultaneously shorted $1,000 of the XLU, you would be betting that the XLE will simply outperform the XLU as opposed to speculating that the XLE will rise or fall in price.

To determine if energy stocks are undervalued relative to utility shares, you can view the ratio of the XLE to the XLU. Since hitting a seven-year low of 1.6 during the heart of the financial crisis in 2008, the ratio has remained in a range between 2.3 and 1.8. As energy stocks have faced downward pressure relative to utility shares in 2014, the ratio of the XLE to the XLU has declined by 23%.

The recent acceleration in the decline of the ratio has pushed two prominent technical indicators into oversold territory, which is a sign that the ratio is becoming cheap.

xle-xlu-weeklyThe weekly relative strength index (RSI) is a momentum oscillator created by J. Welles Wilder that measures overbought and oversold levels. The indicator by default measures each weekly close relative to the prior 14 closes and generates an index that shows the measurements between one and 100. Index readings above 70 are considered overbought and poised for a correction, while readings below 30 are considered oversold and potentially foreshadow a rebound.

A second technical indicator that can be used on the ratio of the XLE to the XLU is the Commodity Channel Index (CCI). The CCI was developed by Donald Lambert and is used to identify extreme market conditions. Lambert originally developed the CCI to identify cyclical turns in commodities, but also can be successfully used to forecast changes in ETFs, stocks and other securities. When the CCI hits readings above 100, the underlying security is considered overbought. When the CCI hits readings below -100, the underlying security is perceived to be oversold.

In analyzing the performance of XLE-XLU ratio since the financial crisis, I found that the week RSI on the ratio moved below 30 five times, and in each case the ratio was higher three months later by an average of 15%. During the same period, the CCI moved below -100 six times, and had shown similar return results. The one time the CCI moved below -100 when the RSI was not oversold, the ratio increased by 5%. Therefore, its it highly likely that the spread will increase in value by approximately 15% over the next three months.

The easiest way to take advantage of a potential rebound in the ratio between the XLE and the XLU is to purchase shares of the XLE and simultaneously short the XLU. For this trade to be successful, the XLE will need to increase in value relative to the XLU.

If you decide to transact this pair trade, you can use the ratio to place a stop. The lowest point since the financial crisis is 1.6, which would be a prudent place to exit the trade.

You could consider taking profits if the spread rebounds to 2.15.

As of this writing, David Becker did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2014/11/energy-stocks-xlu-xle/.

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