Are we seeing a local top in energy? How to tell
The same information that signaled that we were ready for an opportunity in energy is giving a warning that we may be near a local top.
If you've been in the current oil/energy trade since the breakout this summer, you're doing well. Our largest risk to this opportunity is that it is driven by political restrictions to supply and that these decisions can change without notice. While I believe that we have a multi year bull run in energy in front of us, the journey will be volatile which makes a discipline of taking profits and reaccumulating an important part of building and protecting wealth.
We can use several data points to understand where we are in the trend and whether we are close to a reversal. Let's look at these signals, beginning with least responsive and ending with most responsive:
1. Macro tops and bottoms - XLE+XOP/Gold
2. Relative strength
A Heikin Ashi of (
XLE
+
XOP
)/
QQQ
helps us to understand whether the market is shifting between large cap and tech versus the energy trade. This will be signaled by reclaiming the 50SMA and holding the 50EMA as support. The trend remains strong while above the 200SMA and a series of (4 or more weekly) consecutive red Heikin Ashis with a move below the 50EMA will tell us that the trend has reversed. Note the 5-period relative strength of this trend versus the DJI (red) and the 35 period relative strength vs the DJI (green) will both be positive. MACD is an additional supporting visual.
3. CAD/JPY
Canada is a large exporter of oil and Japan is a large importer of oil. When oil is in high demand the
CADJPY
forex pair will trend upward. We can use Heikin Ashi candles again for a better perspective of a shift in trend. Note that the DeMarker and RSI give a number of false signals, so we want to use the 50 and 100 day SMA's rolling over and ADX peak in conjunction with them to confirm reversals. These still show expansion.
4. Leading and confirming (most responsive)
While they have different purposes, different types of oil move in correlation with one another.
If you've been in the current oil/energy trade since the breakout this summer, you're doing well. Our largest risk to this opportunity is that it is driven by political restrictions to supply and that these decisions can change without notice. While I believe that we have a multi year bull run in energy in front of us, the journey will be volatile which makes a discipline of taking profits and reaccumulating an important part of building and protecting wealth.
We can use several data points to understand where we are in the trend and whether we are close to a reversal. Let's look at these signals, beginning with least responsive and ending with most responsive:
- Energy vs gold
- Relative strength and market sentiment
- CAD/JPY
- Leading/lagging relationship with other oils
1. Macro tops and bottoms - XLE+XOP/Gold
- We can identify macro tops of the energy market when
XLE
+
XOP
are making highs while gold divided by oil bottoms (<=18). This will be closely followed by a correlation coefficient between XLE+XOP and gold/oil peaking and likely greater than 0. The beginning of 2021 gave the strongest signal. This is currently on a path toward a local peak.
- Conversely, we can identify macro bottoms in the energy market when gold/oil is peaking (>=30) while XLE+XOP are making lower lows. As this trend concludes the correlation coefficient between XLE+XOP and gold/oil should be close to -1. The most recent signal for a low was mid-March 2023.
2. Relative strength
A Heikin Ashi of (
XLE
+
XOP
)/
QQQ
helps us to understand whether the market is shifting between large cap and tech versus the energy trade. This will be signaled by reclaiming the 50SMA and holding the 50EMA as support. The trend remains strong while above the 200SMA and a series of (4 or more weekly) consecutive red Heikin Ashis with a move below the 50EMA will tell us that the trend has reversed. Note the 5-period relative strength of this trend versus the DJI (red) and the 35 period relative strength vs the DJI (green) will both be positive. MACD is an additional supporting visual.
3. CAD/JPY
Canada is a large exporter of oil and Japan is a large importer of oil. When oil is in high demand the
CADJPY
forex pair will trend upward. We can use Heikin Ashi candles again for a better perspective of a shift in trend. Note that the DeMarker and RSI give a number of false signals, so we want to use the 50 and 100 day SMA's rolling over and ADX peak in conjunction with them to confirm reversals. These still show expansion.
4. Leading and confirming (most responsive)
While they have different purposes, different types of oil move in correlation with one another.
- Oil
CL1!
- After holding the green VWAP anchored to the covid lows as support, oil broke out from the teal descending trend line on 7/7 and tested the yellow 200SMA on 7/13, then reclaimed it as support on 7/21. Note the blue and red VWAPs anchored to the 2022 highs as these will be important areas of support going forward.
- Soybean oil
ZL1!
- Leading signal. The move in oil was preceded by soybean oil which broke out of its descending trend line in June, tested the 200SMA on 7/3, and reclaimed it on 7/19. The most favorable signal for the energy trend would be for ZL to remain above ~$58. A move below ~54 could signal a reversal for oils. Note that ADX is moving into a normal range during this drawdown.
- Heating oil
UHO1!
- Confirmation. The move in oil was followed by heating oil. UHO has more of a rounded bottom below its descending trend line. It moved above the descending trend line on 7/7, but doesn’t reclaim its 200SMA until 7/28. Support at ~3.20 will give a stronger warning of a shift in trend (alignment to VWAP from April 2022 high), with failure of ~$2.90 giving the most concern (where price reclaimed the 200SMA). Note ADX showing signs of exhausted trend.