For much of 2019, the stock market has raged higher with the S&P 500 (NYSE: SPY) 27% higher year-to-date and vaulting to new, all-time highs in the past few weeks. Leading stocks include banks, homebuilders, semiconductors, and software. Even many groups that have lagged for many years like steel, aluminum, or construction stocks have been seeing positive inflows in this bullish environment. Due to high short-interest, they have the potential for big gains to end the year.
Another group with high short interest is energy stocks. Although they have much in common with industrial stocks, they are not seeing any strength yet. Energy stocks continue to lag the broader market. The ETF for energy stocks, XLE (NYSE: XLE) is up 3% on the year, and it remains stuck in a pattern of lower highs. This action is indicative of distribution and lack of demand from institutions. XLE is also below its September highs, while the S&P 500 is almost 5% higher from these levels.
Warning Signs
For energy stocks, three outcomes are possible. The broader market turns lower. Given that energy, stocks are under distribution in an environment where liquidity is plentiful, and risk appetites are strong, they are the most vulnerable to sustained losses if market conditions deteriorate. In a sense, this is the inverse of buying stocks under accumulation when the broader market is weak.
Another possibility is that bull market conditions persist long enough for money to flow into more out-of-favor sectors or for fundamentals to improve. This is the preferred scenario for energy bulls, and the odds of it materializing increase with the passage of a trade deal and continued improvements in manufacturing.
The final possibility is that the status quo persists long enough to frustrate both bulls and bears. The stock market remains in an uptrend, and energy stocks continue to trade in between its December 2018 lows and April 2019 highs.
Poor Fundamentals
The lousy price action in a strong stock market makes it clear that energy stocks are facing serious, fundamental challenges. This is despite several positive catalysts that have failed to meaningfully lift oil prices including increased Mideast tensions, a weaker dollar, and strong U.S. growth.
However, these catalysts are not significant enough to change the fact that oil is in oversupply, while growth in demand has not been as robust. In part, this is due to slowing global trade. It also reflects that increasing efficiency is also starting to mean that growth in oil demand and economic growth is no longer as tightly correlated today than it was in the past.
The Saudi Aramco IPO also affects the picture, as the company is intent on increasing market share to juice its valuation.