As we’ve been predicting in our daily market outlook, the S&P will probably make a small correction soon. The S&P has rallied for too long without a small correction. Only the rally of 1995 lasted. Many small corrections that happen for technical mean reversion reasons also coincide with bearish themes. That’s why we’re trying to find out where the bearish theme for the next small correction will come from. We think it’s oil. Oil and XLE (energy sector ETF) have both been falling recently. Perhaps XLE’s decline will eventually push the S&P down.
History shows that when oil falls significantly, XLE will fall significantly. Sometimes XLE declines will precede the S&P 500’s declines. Here are historical instances in which XLE declines predicted S&P 500 declines.
*In this study, we’re looking at big XLE declines (i.e. 15%+) that preceded S&P declines. Small declines in XLE will have no impact on the S&P in the short-medium term. Energy is not a big component of the S&P 500, so the energy sector must have a big price movement to have a noticeable impact on the S&P.
*Keep in mind that not all oil declines will cause XLE declines. When oil is falling from the top of a range to the bottom of a range, XLE will go up with the S&P 500. Only when oil falls or surges in a strong trend will it impact XLE.
November 3 – December 21, 2015
XLE fell 19% during this period. Meanwhile, the S&P was basically flat (from top of the range to bottom of the range, the S&P only fell 5.8%). Then oil crashed in January 2017 (below $30), XLE crashed 17.8% and the S&P crashed 13%.
As you can see from the following 2 charts, the S&P made a new low in February 2016 while XLE didn’t. XLE led the S&P’s decline and the rally. First chart is the S&P and second chart is XLE.
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May 5 – August 16, 2015
XLE topped on May 5 and started to go down immediately. Meanwhile, the S&P bounced sideways in a range and topped 2 weeks later on May 20.
As oil prices crashed, XLE fell 20.7%. During this time, the S&P formed a flat top and only fell 4.2% (from top of range to bottom of range). So XLE was clearly leading the S&P’s decline.
Then after the majority of XLE’s decline was over, the S&P crashed from August 18 – August 24. The S&P fell 11.2% while XLE fell a relatively modest (for XLE standards) 15.5%.
First is the S&P’s chart while second is XLE’s chart.
November 21 – December 16, 2014
This is a case in which a big XLE decline was not followed by a small S&P correction.
After a counter-trend rally, XLE gapped down and got crushed. It fell 18.7%. Meanwhile, the S&P was rallying throughout all of November and only fell 4.7%!
First is the S&P’s chart, second is XLE’s chart.
June 23 – October 15, 2014
Before the S&P topped on September 19, XLE had already fallen 8%. Keep in mind that during this time, the S&P rallied 2.8%!
Then the S&P fell almost 10% from September 19 – October 15, while XLE crashed 19.2%. Overall, XLE fell 23.6%.
1st chart is the S&P, 2nd chart if XLE.
February 24 – June 4, 2012
By the time the S&P topped on April 2, XLE had already fallen 8.2%. Then the S&P fell 12% from April 2 – June 4 while XLE tanked 16.26%. Overall, XLE fell 20.1%.
1st chart is the S&P, 2nd chart is XLE.
Conclusion from the historical cases
Whenever XLE declined and the S&P did not make a small correction, the S&P always made at least a small correction pretty soon. Sometimes a big correction ensued. There was only 1 exception to this rule.
*There were no cases from 2003-2007 in which XLE’s decline preceded the S&P’s decline. This is because oil was in a bull market in the 2000’s, so rising oil prices resulted in a very steady bull market for XLE.
The current case
By comparison, XLE has fallen 16% in 5 months from December 2016 to May 2017. Meanwhile the S&P has continued to rally significantly! Thus, it’s highly likely that XLE will continue to fall and that the S&P will at least make a small correction.
Our hypothesis was right. It’s likely that the S&P’s next small correction will be driven by falling oil and XLE.
However, our model says this is still a big rally in a bull market. We ignore small corrections. That is why we are still 100% long UPRO (the S&P’s 3x ETF) even though we foresee a small correction in the near future.