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Conclusion: One mother of a short-squeeze does not a trend make, but both our fundamental research output and quantitative risk management signals suggest overweighting energy into/through year-end is the most appropriate debate investors should be having right now.

Earlier today on our Q4 2015 Macro Themes presentation, Keith reiterated that we are firmly in “do nothing” mode with respect to energy. In money management speak, that equates to us having a neutral exposure to the sector vs. the benchmark (long-only) or a net exposure of zero (hedge fund).

As the originators of the #Quad4, #GlobalDeflation view that helped clients position for the [subsequent] crashes in energy, commodities and inflation expectations, globally, this shift to neutral is extremely noteworthy – as is the fact that the net exposure to commodities in our model asset allocation is at the highest level since the June lower-high in global reflation expectations.

Since most investors are not positioned for energy to lead the market higher, we thought we’d offer our detailed thoughts on this developing risk. Specifically, at 7.3% of float, energy is the most heavily shorted sector in the S&P 500. That ratio is 297bps above the aggregate market and the next closest sector, consumer discretionary, is a distant -90bps behind. Indeed, investors are still very bearish on energy.

Risk Managing the Shift to #Quad3 – Especially in Energy - Short Interest as a   of Float

Why has energy lead the market higher over the past month (XLE +13.2% WoW and +7.1% MoM vs. +4.7% and +2.2% WoW and MoM, respectively, for the S&P 500)? Because of the ongoing shift to #Quad3 – economic growth slowing as reported inflation readings accelerate – and the dovish response we have gotten and may continue to receive from the Fed in the ensuing months.

Risk Managing the Shift to #Quad3 – Especially in Energy - UNITED STATES

Risk Managing the Shift to #Quad3 – Especially in Energy - WORLD

We discussed this move to #Quad3 – both domestically and globally – in great detail during the aforementioned presentation. You may use the following hyperlinks to the extent you’d like to view the video replay or download the slide deck:

What does #Quad3 entail for equity investors? Historically speaking, #Quad3 is not a great place to be in that the stock market tends to exhibit flat-to-down absolute performance, as well as experience multiple compression:

Risk Managing the Shift to #Quad3 – Especially in Energy - SPX

Risk Managing the Shift to #Quad3 – Especially in Energy - S P 500 Multiple

There are, however, places to “hide”:

  1. Utes
  2. Energy
  3. REITS

Risk Managing the Shift to #Quad3 – Especially in Energy - Utilities

Risk Managing the Shift to #Quad3 – Especially in Energy - Energy

Risk Managing the Shift to #Quad3 – Especially in Energy - FTSE NAREIT Index

For what it’s worth, our Tactical Asset Class Rotation Model (TACRM) is indeed confirming the move to move to #Quad3 across a variety of factor exposures – just not yet at the primary asset class level given that such regime changes take more time to occur:

  • 7 of the top 10 factor exposures signaling the highest degree of positive, risk-adjusted VWAP momentum across multiple durations throughout the global macro universe of investable assets are tethered to rising inflation expectations: U.S. E&Ps (XOP), U.S. REITS (VNQ), Global E&Ps (FILL), Gold Miners (GDX), Silver (SLV), Palladium (PALL) and Sugar (SGG). [slide 16]
  • All seven are signaling investable bearish-to-bullish reversals as well. [slide 16]
  • Within the “U.S. Equities” asset class (as defined by TACRM), 3 of the top 4 factor exposures signaling the highest degree of positive, risk-adjusted VWAP momentum across multiple durations are tethered to rising inflation expectations: Large-Cap Energy Producers & Servicers (XLE), E&Ps (XOP) and Gold Miners (GDX). [slide 17]
  • Within the “International Equities” asset class, the factor exposure signaling the highest degree of positive, risk-adjusted VWAP momentum across multiple durations is tethered to rising inflation expectations: Global E&Ps (FILL). [slide 18]
  • Within the “Emerging Market Equities” asset class, the factor exposure signaling the 2nd highest degree of positive, risk-adjusted VWAP momentum across multiple durations is tethered to rising inflation expectations: the economically embattled Russia (RSX), of all places! [slide 19]
  • Within the “Domestic Fixed Income, Credit & Equity Income” asset class (as defined by TACRM), the factor exposure signaling the highest degree of positive, risk-adjusted VWAP momentum across multiple durations is tethered to rising inflation expectations: REITS (VNQ). [slide 20]

When TACRM speaks, investors would do well to listen. Note the timestamps on its latest top-down signals, as well as the historical backtest data, which can be found on slides 7-13 of the presentation: http://docs3.hedgeye.com/macroria/TACRM_10082015.pdf.

All told, the material bounce in energy related assets appears to be a classic #Quad3 style factor rotation – which means the probability that it continues is likely much higher than the probability that it does not.

Just don’t chase energy from these prices, however, given that the XLE is both immediate-term TRADE overbought and requires additional confirmation from the perspective of our intermediate-term TREND signal:

Risk Managing the Shift to #Quad3 – Especially in Energy - XLE

Moreover, there are a couple of signals within TACRM that support waiting for confirmation here as well:

  1. The underlying commodity itself (OIL, USO) has not yet signaled a bearish-to-bullish breakout. [slide 22]
  2. The U.S. Dollar (UUP) has not yet singled a bullish-to-bearish breakdown. [slide 21]

That said, if the aforementioned risk management thresholds are met, investors would do well to get behind the rally in energy (and other #Quad3 style factor exposures) because that is likely where the preponderance of alpha will be generated into/through year-end.

Best of luck out there,

DD

Darius Dale

Director