Too Late to the Oil Party? Consider an Alternative (Part II) 13 comments
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Occasionally, one gets it right. In my market comment last month ("Too Late to the Oil Party? Consider an Alternative"), I remarked:
Though I am a long-term bull on energy, oil has already more than tripled in the past four years. In my view, after this move, the probability of major price corrections and volatility is currently very high.
While I was on vacation for the first three weeks of July, I was very glad to be out of all investments tightly correlated to conventional energy, after happily riding them for several years.
However, the alternative energy sector -- which I believe is due for a major positive move in the medium to long term -- has not exactly lit things up this last month. Most of the major stocks are flat to down, with the PowerShares WilderHill Clean Energy ETF (PBW) on which I focused in my analysis, down just over 10% in that time.
But this is all in absolute terms, and when it comes to markets, I believe in a financial principle of relativity: all performance is relative. And when you look at the relative performance of PBW and the oil ETF (USO) it looks like, in relative terms, the party for alternatives may have already begun.
Financial Relativity: The Special Relativity of Oil and Alternative Energy
The chart below is a depiction of the relative performance of PBW versus USO for the last year (click to enlarge image):
During the last two weeks, where the arrow indicates, a major linear trend in the relative price of PBW and USO looks to have statistically broken. For the previous six months, alternative energy consistently lagged conventional energy, but during the recent pullback in oil, this relationship has broken out of its statistical "channel". Whether this is a mere "test" or the beginning of a true reversal is yet to be seen, of course. But for a long-term investor confident that alternative energy has the fundamentals of supply and demand on its side, it is a sign that the wait for a bullish move may soon be over.
Beyond market fundamentals, I think that the upcoming election may provide a catalyst for capital flow towards alternative energy equities. Unless oil prices really tank over the next few months -- back into the sub-100 dollar range per barrel, which I don't expect -- I believe it's quite likely that Obama and McCain will get into an escalating battle about who is more supportive of alternative energy. This sort of attention would provide additional support for the sector and help it to break out of its six-month trend of underperformance relative to conventionals.
The most direct way to apply the financial principle of relativity is through pair trading, or through more complex variations on the same theme. Properly executed, these strategies can allow one to play the relative performance of alternative energy versus oil, for example, while remaining agnostic regarding the absolute price of oil.
Abstraction and its Discontents
It's vitally important to come up with simple visual representations when you delve into the realm of even basic abstractions like relative performance strategies. Any responsible quant knows that while useful analyses get multidimensional and abstract pretty quickly and naturally, you should never surrender entirely to the abstraction and trust it without struggling for intuitive understanding. In the map of the financial world, going that direction -- into quantitative la-la land -- leads to wrecks like Long Term Capital Management and dear old Enron. The physicist Richard Feynman once attempted to explain a point of quantum mechanics at the freshman level and said, "I couldn't do it. I couldn't reduce it to the freshman level. That means we really don't understand it." Many financial quants forget this, and instead embrace "the smartest guy in the room" pretensions, flaunting and even exaggerating abstraction because they think it makes them look smart.
I'm not the smartest guy in the room, I'm a monkey evolved for picking fruit and avoiding saber-toothed cats. As a visual beast, I like to visualize abstract ideas whenever possible. While I am certainly not a classical chartist, like many market participants I find that candle charts and their variants are useful tools to visualize market patterns. They are nicely balanced between providing a lot of relevant information while still being intuitive and simple. The relative movement chart of PBW and USO above is a "shadowless" variant of the traditional candle chart, with up days (close > open) in white and down days (close < open) in black; it efficiently shows the recent increase of buying interest in alternative energy relative to oil.
General Relativity in the Markets
For any reasonably-sophisticated market participant, this sort of relative performance analysis is quite generally useful to have in your bag of tricks. In my quantitative financial modeling, I find it interesting how many reasonably-persistent linear relationships appear when one looks at the relative performance of market sectors, for example. Such simple relationships occur far more often in relative terms than in absolute terms. So the financial principle of relativity is special not only to alternative energy and oil, but is indeed quite general.
In fact, if one takes a thoroughly relative view of markets, bull markets and bear markets become almost subjective fallacies. In nautical terms, what matters is not the ebb and flow of the tide, but your hull speed through it. In the long run, that is what counts. The tide will eventually turn. In market terms, during the ebb and flow of the markets, losing less during bear markets is just as good as gaining more during bull markets, even though it seldom feels as good. (This is wherein lies the truth of the old adage: "You make the most money in bear markets. You just don't realize it at the time.") In more general terms, in a limited and competitive world your economic position depends not on how much money you have, but in how much money you have relative to those with whom you compete. Take it from a fruit-eating monkey who dreams in equations.
As in my market comment a month ago, for this analysis I use PBW, the PowerShares WilderHill Clean Energy ETF, as a proxy for alternative energy, but there are a number of analogues which are fairly closely correlated with PBW. These include the PowerShares WilderHill Progressive Energy ETF (PUW), PowerShares Cleantech ETF (PZD), and the Market Vectors Global Alternative Energy ETF (GEX). There are, of course, many major individual equities in the alternative energy space, such as Evergreen Solar (ESLR), First Solar (FSLR), JA Solar (JASO), Energy Conversion Devices (ENER), Suntech Power (STP), and Trina Solar (TSL); although individual equities in a rapidly expanding industry tend to be very volatile, and are not for the faint of heart.
Disclosure: I eat my own cooking, as they say. I am currently (as of late July 2008) long alternative energy, through positions in the PowerShares WilderHill Clean Energy ETF (PBW).
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This article has 13 comments:
Just so you don't get a swelled head, I'll guess that 1000 chimps, banging away on 1000 keyboards, for 1000 days, could have come up with the same article.
well, Kailing, how about volatility in oil prices...yes they are down now, but for how long?
also, speaking of clean energy, the only viable hydrocarbon substitute as far as i can tell, is algal fuel. what about those companies?
irproducts.com
p.s. Short the Bear & Long the Bull.
Don't forget that nuclear power also contributes to global warming. They use water to cool down the reactors which at the same time warming our water and melting our ice.
If we don't want an environmental dissaster (due to emissions) and don't want to kill millions of people (due to future nuclear waste) we should really invest in alternative energy such as solar and wind.
I am a long term investor and believe that solar gains will be huge. I urge other people to invest in alternative energy as well.
BTW, I doubt that oil will go below 100 since growing economies such as China and India will keep the demand as well as the price for oil high.
See levels are already rising, so it's a fact that we contribute a lot to global warming. Too bad people are still thinking about countries and not about a planet as a whole.
Disposal of the waste is just one of many problems with nukes.
Here are more.
It cost about $500 million to dismantle a used up nuclear plant.
We import most of our uranium, with Russia seen as a future major source.
According to Argonne National Laboratory, an airliner crashing into a nuclear power plant could cause complete meltdown, even without cracking the containment building.
Due to the Price Anderson act, nuclear power operators aren't liable for any accidents that may occur.
We are already subsidizing nuclear more than we are solar and wind
Water to cool the hot exhaust is needed in vast quantities.
In a world of changing climates, how do you guarantee enough water? Not to mention the coming problems with water supply, world wide. One plant in Alabama was already shut down briefly this year because of a drought, not enough water to cool the plant.
Solar and wind are much quicker to get up and running than nuclear or coal plants.
As far as Obama and McCain both promoting alternative energy, all McCain wants to talk about, (like his party in general) is more nuclear and drilling offshore and in ANWAR.
Maybe GOP stands for Grand Oil Party
When you suggest taking a little of the $84 billion in annual tax credits and subsidies from the oil industry, and redirecting it to alternatives like solar and wind, They (GOP) refer to it as raising oil company taxes.
And everybody knows we don't like raising taxes, right?
Oh how gullible they assume Americans to be.
For frflyer, your comments regarding probs of nuclear energy are very appropo and informative. Another huge potential prob is the escalating cost of uranium as dozens or hundreds of new nuclear plants come online around the world in next decade. Your comments about the GOP (Grand Oil Party) are far off the mark because of political blindness. The simple truth is what Calvin C. noted: "solar and wind are barely making a dent in our huge energy consumption (<3%)". I am long solar (STP) but lets get real -- we either get more domestic oil/gas production in the next 10-15 years or the days of the great depression (1930's) will look like prosperity. "Consume less! Drill more!"