A Dash of Insight

Oil Prices and Stock Prices

Yesterday we wrote about the link between oil prices and energy ETF's, including stocks that should be responding to long-term expectations, not the front-month spot prices.  There is a lot of "floating storage" right now.

There is an expiration effect, with a front-month imbalance.  Meanwhile, the effects drive down the prices of anything in the energy sector.

The Role of Speculation - a New Concept for Links Posting

Last night, 60 Minutes had a segment on oil prices, emphasizing speculation and the need for greater regulation.  There were some good points in the segment, but we found the overall impression to be quite misleading.

Regular readers know that we are big fans of those who are the gatekeepers of the Internet, and we feature the sites that do this well.

Here is a new idea:  How about pulling together links on a specific topic, providing the intelligent reader an opportunity to see a range of thought on the issue.  The articles do not always appear on the same day, the general format for the gatekeepers.

Let us give it a try.

Our own explanation about the over-emphasis on the front month.

Eddy Elfenbein's excellent take on what 60 minutes should have asked, but did not.  You can also see the complete video.

Barry Ritholtz analyzing what 60 minutes missed.

Todd Sullivan, looking at how actual supply and demand affected prices.

And most importantly, how a thoughtful economist, writing peer-reviewed work analyzes the role of markets and speculation in influencing prices.  This is not an easy read, because it is detailed and analytical, with plenty of charts.  It is quite clearly argued, and accessible to anyone willing to take the time.  Investors should follow the excellent work of Prof. James Hamilton here and here.  It shows the oil price influence on the recession, and what we should be watching.

Conclusion

It is always a challenge to look forward, but the information is there for those willing to make the effort.  The overall conclusion is that speculation is only part of the effect on prices, with a need to balance the various factors.  Our own view is that forward pricing is a good leading indicator.

Can You Play ETF's for a Rebound?

There are many great reasons to invest via ETF's -- low costs, focus on sectors, diversification, and others.  We embrace these good reasons in our TCA-ETF trading program and have written about the ETF advantage for more than a year.

Our methods got our long-only fund out of harm's way for the worst of it.  While we do not often do explicit market timing with short ETF's, preferring to use these for hedges, that would have worked even better over the last two months.

For an investor, trader, or fund manager, it has been a challenge to get the timing right.  It is fine to say that last week was the biggest gain in DJIA history, but you had to be invested for the big day.  If you were not there in advance, how many people would really chase the rally?

Our ETF approach has had us out of the market, a success.  It was a little slow, with some losses from hanging on with gold stocks and some energy holdings when there was really no safe haven.  It will also be slow getting back in.

Sleeping Well

There is a lot to be said for getting out when the risks were high, as we noted in When Cash is King.  We are confident that when the market stabilizes and sectors start to emerge, our TCA-ETF model will identify some good choices.  We are equally confident that it will miss the initial rebound.  (For new readers, there is a more complete description of our methods at the end of the article.)

Is there an alternative?

Even a great sector model like ours is not geared to catching the bottom.  That is why we are closely following our Gong Model, which uses various technical criteria to find an  "all clear" signal for investors.  This does not mean that we will have an instant winner.  It means that there is a dramatic change in the risk/reward.

ETF investors can act on this in two ways:

1. Invest in a general market long like SPY or QQQQ, choosing the Gong Model over the TCA-ETF approach.
2. Pick stocks.  Sometimes the market does not favor the ETF approach.  It is important to recognize this.

We plan to do a little of both in our fund.

Stock-Picking

One approach to finding stocks is to take hard look at the strongest survivors.  David Merkel at The Aleph Blog, has been one of our featured sites from its inception.  We admire David's disciplined approach to finding the right stocks and rebalancing on a regular basis.  These are important keys to success.  David has a list of stocks from his most recent screen.  Investors should carefully read his analysis and logic.  Take a look at your holdings, and see if they are on the list.  For our individual long-only accounts we checked the list to take a careful look at anything not mentioned.

Charles Kirk, another of our featured and favorite sites, uses regular and successful stock screens to pick winners.  We were particularly interested in a recent post where he discussed passive investment methods.  This is a great source of ideas and the stock versus sector discussion.  (And also many thoughtful links).

James Altucher, writing for RealMoney, highlights many interesting stocks, carefully tracked and discussed on Stockpickr.  Today's edition highlights stocks from this week's Barron's, selected for favorable factors like insider buying, cheap losers, dividends, and other factors.  (Full disclsoure:  We write as a contributor to RealMoney.  Regular readers know that we bought the service before joining and we are long-time fans of James Altucher.  It is worth the price).

Our own approach is a bit different, a bit more optimistic than David's.  We are looking for stocks that fit one or more of the following criteria:

1. Solid stocks on balance sheets and intrinsic value that can explode if the perception of the economy improves.  (Out of favor, but that is what the savvy investor seeks).
2. Stocks that were taken down during forced selling by hedge funds.  These are companies that are not really sensitive to economic concerns.  The price declined with the general averages.  When the extreme volatility declines, these will be winners as managers think more carefully about individual issues.
3. Micro-sector plays.  Some sectors, like energy, have declined with the price of oil.  Not all energy stocks are equal.  Some maintain strong earnings power, even in the face of lower oil prices.  Regular readers know that Transocean, Inc. (RIG) is a favorite holding meeting this criterion.  There are others.  The key is that not every "energy" company is immediately sensitive to oil prices, even if the stock price is.

We are making these adjustments for our clients right now, and will share some of the choices in future articles.

Summary

We are obviously big fans of the ETF and sector approaches, but it might not capture the first part of a rebound, if and when we get one.

Weekly TCA-ETF Rankings

We have been out of the market in our fund, since the charter is basically long only.  For readers interested in our program, we have a long-only method and one that embraces more market timing.  We are working on a report that tests these alternatives in a variety of circumstances.  Current reports are available to any interested reader -- both the TCA-ETF method and the Gong Model.  Just use the "email me" link at the top left of the page.

We have never seen readings so negative.  Despite this, we switched to neutral in the weekly Ticker Sense blogger sentiment poll, because we anticipate the imminent ringing of The Gong.  Readers need to check out the model description to realize just how negative the picture has become.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.

Energy Opportunity

Oil futures had a knee-jerk reaction today as the market factored in a decline in air travel and jet fuel consumption.  Since many hedge fund managers trade energy ETF's as if they were proxies for oil futures, this may provide an opportunity.  The reaction is based upon a directional decision, not an assessment of the fundamentals.

The reasons for selling include factors that are all subject to question, something I described on our energy site.

The opportunity for investors depends upon how one views the upstream versus downstream energy companies.  The behavior follows the Cobweb Model, where reaction depends upon how the companies needing new production view the future of demand.

The next question is how to interpret the behavior of the "big uglies" as some call the integrated oil companies.  There is evidence that their announced capex expenditures may not lead to major increases in supply.

We can review this by looking at what major integrated oils are actually doing on capex.  ExxonMobil is a good example.

My conclusion is that E&P companies, despite the recent lackluster performance, are only reflecting oil prices of $40/barrel or so.

Investment in ETF's has distorted this market, presenting an opportunity to investors who understand how upstream and downstream really works.  Full disclosure --- my funds and investors have some energy positions in these holdings.  This has been a good move -- at least until very recently.  Over the last two years any decline has provided a good opportunity to add.  Since the fundamentals look the same, I seek to add to my positions with some new names.

More Overreaction in Energy Stocks

The higher volatility in these stocks makes no sense, but it comes with the territory.  Here's the story, and I'll explain more below.

Link: Energy ETFs Leak Oil.

Bloomberg reports that Crude oil fell on expectations that milder temperatures in the U.S. will help preserve stockpiles of winter heating fuels that are above average levels. Warmer weather is forecast for most of the U.S., with temperatures in...

Energy Trading - Background

There is so much attention on oil prices that it seems like CNBC has become the Energy Channel.  It is not surprising.  The energy "sector" is up over 20% on the year and also accounts for the largest segment of earnings growth.  The S&P uses the term "sector" as it is defined in Morgan Stanley Capital International's Global Industry Classification Standard (GICS).

Many -- perhaps most -- of those in the parade of talking heads on CNBC, and online pundits as well, talk about energy in this same broad fashion.  Everyone wants to act informed, including those who paid little attention to energy stocks before this year.  The result is that nearly everyone says things like "You have to own energy," or "We like the energy names," or "We have been doing well in energy."

Our own sector definitions are much narrower, more like the sub-industries in the GICS system.  For trading purposes these definitions are much sharper.  Here's why.

The broad energy sector as defined in the GICS system includes a wide range of companies including the following:

• Companies that own oil reserves
• Companies that explore for oil
• Companies that build exploration equipment
• Natural gas and pipeline companies
• Refiners - who buy oil from others and sell a finished product
• Shippers - who transport either crude or refined products
• Large integrated oil companies who do most or all of these things

The S&P 500 includes 28 companies covering the gamut listed above.

These companies do not all benefit in the same way from changes in oil prices.  Those that have large reserves will benefit from higher long-term prices when they sell the reserves.  More important for stock valuation is the impact on earnings.  A spike in prices may be good for the integrated companies, but have no real implications for the drillers or oil services companies.

More later..