How Much Longer Can Money Managers Hang in Behind Energy?

Includes: XLE, XLF
by: Bill Cara

In markets today, there is a subtle shift of capital flows going on that I have observed, and which bears watching. As the economies of Japan and Europe are now showing the weakness that I was writing about for months as the untold story, the US Dollar has strengthened along with the US equity market. This does not mean a new Bull market for stocks has started, however.

The fact is that the growth rate of the global economy is rapidly slowing, with large pockets of recession, and the rate of producer and consumer inflation is far higher than the comfort level of any respectable central banker. The major financial services companies (banks, broker-dealers, insurance companies) have yet to write down their so-called asset backed commercial paper holdings to market values, which is the reason these companies are illiquid and have limited funds to lend to producers and consumers. This credit crunch leads to a quandary for capital managers, producers and consumers alike. Where capital has been flowing has nothing to do with Bull markets or bullishness and everything to do with a desperate attempt to find safe havens.

Some capital managers are in denial; others are cranking out their excuses because they fear that the Other People whose Money they have been managing improperly are about to become an ugly crowd of litigants.

After the Financials (NYSEARCA:XLF) peaked on October 5, 2007 at 35.97, before plunging -53.4% to 16.77 on July 15, there were carefully crafted stories of oil shortages, refinery shortages, and the like, which served to move that capital from XLF to the energy sector (NYSEARCA:XLE). XLE then moved from a low of 62.97 on Jan 23 to a high of 91.42 on May 21. That move kept the major equity market indexes from outright collapse, even though the DJIA index did manage to fall -23.7% from a high of 14198 set on October 11 to a low of 10828 on July 15. The total capital transferred from Financials to Energy was in the mega trillions.

But, today, after a rally of +27.3% in the Financials from 16.77 (July 15) to 21.35, traders understand that the credit markets are still in a major crisis with extreme spreads getting worse, and more banks are failing every week. So they are not chasing the Financials higher, in fact the XLF peaked between late July and early August. That dinner’s been eaten.

Moreover, following the highs in XLE from May 21 through into July, traders now recognize that growth in the global economies cannot sustain crude oil prices in the 120-145 range, and so are knocking the price down, likely into the 80 range this Q4 and 1H09. So XLE dropped from a high of 90.16 on July 2 to a low of 68.35 on August 18. That was a drop of -24.2% in six weeks in the industry with the world’s largest market value, which shows the power of these money flows. Now, just two weeks later, possibly because of fighting between the Russians and Georgians and possibly because of a major threat of Hurricane Gustav to the US oil fields in the Gulf of Mexico, the XLE has recovered +9.2%.

How much longer can money managers hang in behind XLE, knowing that the global economy is in dire straits, the credit crunch cannot be terminated until the Financials complete their write-offs and restructure/raise more capital, and the political direction of America is decided following the removal of eight years of Texas oil people in the White House?

In that regard, I think the choice of oil lobbyist, gun-toting, right-to-lifer Alaska Gov. Palin for running mate on the Republican ticket is a clear indication of the GOP stance with respect to their biggest political supporters. That’s not to say I disagree with those positions, although I am surprised with the choice of a political unknown. America has this thing about the star system. I’m sure if Hollywood can make stars of people like Paris Hilton, Gov. Palin ought to be an easy Manolo Blahnik fitting.

Not to make jokes, but if they have already started from the likes of The Daily show and CNN’s lead news anchor Wolf Blitzer nonetheless, this is going to be a tough convention and campaign for the GOP.

Blitzer, soon after reporting that Palin had been chosen as the McCain running mate, was informed by the reporter who broke the story that his digging into her barely known past revealed that Gov. Palin had been an athlete on the high school volleyball team, where she had been known as ‘Sarah the Barracuda’. Said Wolf, in response, “Our little Sarah was quite the high schooler”.

I think she’s being portrayed as Rodney Dangerfield by media leaders who are serious about the problems of the country and the steps being taken to turn around the situation. I’d like to say that I find it a bit unfair; but really is it? Texas Senator Kay Bailey Hutchison, one of the most prominent Republican women in the nation, was startled at the announcement, while being interviewed at the time on CNN, and admitted she didn’t know Gov. Palin. Many of the CNN long-time reporters also said the same.

So, back to the market. Where are we, if, as I say, the Financial and Energy stocks, which are by far the two biggest industry sectors in the equity market, are going nowhere? (I won’t even argue here that they are going south, although I could, but I just need to figure out what money managers are doing now and let the market move where it wants.)

After Energy and Finance, is capital flowing into Tech (NYSEARCA:XLK) maybe, since that’s the next biggest sector? No, not there either. In the past three months, XLK has dropped -9.7% and the Semi-conductor group (my leading indicator for Tech) is down -12.8% in that time, and -6.3% in the past two weeks alone, while the S&P 500 is down just -1.1%.

Yes, where is the capital flowing? I say it’s going into safe haven places like US Treasuries. The TLT is up +2.5% in the past four weeks, despite inflation data that is rocking and rolling.

Another pocket, although it may turn out to be full of holes, has been the small cap stocks. For instance, the Russell 2000 index rallied from a July 15 level at 673.76 to a high of 764.38 on August 15, which was a one-month gain of almost +13.5%, and the current price is still at 739.50.

Driving T-Bill yields down well below short-term rates is not an effective long-term strategy for bullish traders. Some say, it’s nothing more than a panic move. But, really, where else are traders – particularly the ones who absolutely must pursue a long only strategy -- supposed to do?

Doesn’t this situation go to show that the mutual fund model no longer works? There are times that traders cannot afford to be 100% long, even with large cash positions.

After the close Thursday, up +213 points in the DJIA index and +329 points over three straight days of gains, I opined early Friday that my 10000/2000 opinion (it’s not a forecast; it’s a guess) was still in place. The DJIA on Friday sold down -172 points, most of it in the late afternoon. Traders have not started a Bull market; they are not even bullish. They are scared.