USO, XLE May Have a Power Shortage

As the market continues along in its corrective process, there are a few groups that have not taken part in the weakness to any significant degree. Currently, the leadership stocks are where the short-term risk remains. We highlighted a few examples of this in the agriculture space that we believe still have further downside risk. We aren't looking for huge declines, but some further corrective selling seems likely.

Another sector with similar downside potential is energy. We have been energy bulls for quite some time, but are seeing price action that suggests some bumps in the road may be surfacing.

Again, we aren't making any longer-term predictions about the price of oil or the energy stocks. We are suggesting that for the short term, this sector remains vulnerable to some further weakness. As the recession fears mount the theory would be this slows the consumption of oil. If those fears become reality, or if overseas growth is ultimately impacted, we could see the demand for oil drop off and a subsequent price decline.

U.S. Oil Fund

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If we take a look at the U.S. Oil Fund (USO - commentary - Cramer's Take), we find that the configuration is looking distributive near-term. There is a failed breakout in early January when crude oil was unable to hold above the $100 level for the second time. That failure led prices lower, bringing the ETF back toward the $70-$71 area. This level happens to correspond to the lows seen during the pullback after oil reached $100 for the first time. As a result, a trading range has been created, but each subsequent rally has lacked in upside momentum.

The key support in the USO is now in the $68-69 range. A break of this level would suggest further weakness to the low $60s. Using Friday's strength in oil we can short the USO with a stop in the $73 to 73.50 level. This sets up a favorable risk/reward scenario.

Energy Select Sector SPDR

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As far as the energy stocks go, any weakness from the price of crude oil should negatively impact the energy stocks as well. The Energy Sector Select ETF (XLE - commentary - Cramer's Take) is also showing some deterioration, as oil prices have softened and the market has struggled.

This ETF has been under pressure and is also vulnerable to further downside. Any strength to the $70-$72 level would provide an excellent entry point for short trades. We would consider establishing short positions at current levels or on strength to the $70-$72 level. As far as downside potential, we can see a move lower to the $60-$62 area.

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At the time of publication, John Hughes and Scott Maragioglio were short U.S. Oil Fund and the Energy Select Sector SPDR. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.