Energy Sector Feels the Problems of Success

We have been bullish on energy of late, discussing the upside potential for the sector and the possibility of that strength spreading out to other areas, such as natural gas. We have seen the price of oil rise to record-setting levels at an almost unrelenting pace. This has translated into strength in the energy stocks, but the amount of strength or the degree of that strength has been weaker than we would have expected. In many ways it has been disappointing, considering the strength in the basic rise of the commodity price.

Maybe we shouldn't be so disappointed. After all, many of the energy stocks have had good, solid rallies. They have been good absolute and relative performers. What is happening now is they are losing some relative performance vs. the price of oil itself.

This signals one of two things. First, investors do not think the recent rise in oil prices is sustainable, and instead believe the recent rise is due to short-term geopolitical issues.

The second reason could be concerns about economic issues. At some point, rising oil prices lead to slowing growth. The rising cost means that eventually there will be less demand as consumers adjust to the higher prices. We may be reaching that level, and that suggests the continued assumption that there are higher prices for energy at these levels isn't prudent.

Financial Select Sector SPDR

Click here for larger image.

More important to us is the internal technical configuration of the sector, and that is becoming increasingly worrisome. Our 40-day SARSI indicator is beginning to show some negative divergences against the Energy Select Sector SPDR (XLE - commentary - Cramer's Take).

This is a situation where we are seeing fewer and fewer stocks within the sector participating in the strength. In fact, the XLE hasn't even made a new high along with the price of crude oil, creating a situation where oil stocks in general are not keeping pace with the price of the commodity.

The earnings season has led to some concerns as well, with some of the leadership names, such as Exxon Mobil (XOM - commentary - Cramer's Take) and Schlumberger (SLB - commentary - Cramer's Take), not meeting expectations.

In the case of Schlumberger, they reported good earnings, but expectations were so high that it was almost impossible for the company not to disappoint. It is increasingly becoming a situation where the good news is getting built in, and there is little room for further appreciation.

This is a problem of success, and it happens to all the leadership stocks at some point. We aren't suggesting we have to run out and sell our energy stocks here, but we should begin to rethink the scenario of what appeared to be an endless rally and take a more cautious approach. Protect profits in this sector and be patient on any new buys.

---

At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. 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.