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Energy Stocks: Time to Buy the Dip? | $XLE - reflation cartoon 10.13.2015

What the heck is happening in the Energy sector (XLE)? Energy stocks have trailed the S&P 500 by a whopping 15% in 2017, down -8.7% versus +6.7% for the broader stock market. It's also the only sector in the red this year. But if you're a long-term value investor looking to buy the dip in Energy stocks, we suggest you seriously reconsider. 

Energy Stocks: Time to Buy the Dip? | $XLE - sectors 4 26

Why It's Happening

If you're scratching your head trying to figure out the catalyst that's crippled energy shares in 2017, here's some intel. "If you model macro like we do, you'd know inflation's peak and rollover started in late February and early March," writes Hedgeye CEO Keith McCullough in today's Early Look.

The Consumer Price Index (CPI) is an inflation proxy and carries a 10% weighting to energy. It's no surprise to us that two weeks ago, CPI slowed from a five-year high of 2.8% year-over-year in February to 2.4% in March. We expect reflation to continue to dissipate over the coming quarters as commodity prices, which were previously in the doldrums throughout 2015 and 2016 (see chart below), ease off their recent rebound (contributing a lesser pop to year-over-year inflation numbers). 

Energy Stocks: Time to Buy the Dip? | $XLE - reflation falling

Reflation's Rollover

The market nailed this. That's why energy stocks have had a dismal 2017 as Oil prices fell -11% year-to-date. Meanwhile, the market's inflation expectations, as implied by 1-year, 2-year and 5-year breakeven inflation rates have slowed materially since late February.

(Note: The 5-year breakeven inflation rate, for instance, is calculated by subtracting the 5-year Treasury yield from the 5-year yield on Treasury Inflation-Protected Securities.)

Energy Stocks: Time to Buy the Dip? | $XLE - 04.26.17 EL Chart

Time To Buy Energy Stocks? No

The precipitous drop in Energy stocks (XLE) is tempting for long-term value investors. But watch out. "Oil Volatility (OVX) is still at 29, so I’m waiting and watching on this one as Reflation’s Rollover still has me out of Energy Stocks," McCullough writes in a note to subscribers this morning.

Stay nimble. More to be revealed.