Are Energy Stocks the Next Shoe to Drop?

There had been three sectors that significantly outperformed the S&P since the June lows: Technology, financials, and energy. 

One has already bitten the dust.  Technology (NYSEARCA:XLK) broke down and is now leading the market lower, down 10% from its September highs on the back of  fading Apple mania compared to financials down only 2% and energy 7%.  We continue to watch the financial and energy sectors closely for their potential relative strength breakdowns which would add weight that a longer term market top is occurring.

More than Meets the Eye: Financial Stocks

On 7/21 in our August newsletter we alerted our subscribers how the energy and financial sectors led the market higher and lower over the past two months and how they would also lead to the downside.  "Their underperformance and breakdown in early May helped identify the market's change in trend from up to down and we are expecting a similar event at the market's next juncture. Until these sectors break down, the market's top likely is not in place".  Financial and Energy stocks were up 12% and 9% into the market's peak in September.

Similar to Apple-Mania, an article from 11/6 "More than Meets the Eye: Financials" focused on the impact that just 3 companies have on the financial sector that contains over 80 companies.  Due to their market caps, those three companies make up over 25% of the XLF (NYSEARCA:XLF) index and following them (as opposed to all 82) will likely give you all the insight needed as to the financial sector's direction.

More than Meets the Eye: Energy Stocks

As of the September quarter end, the Energy Select Sector SPDR (NYSEARCA:XLE) makes up over 11% of the S&P 500 by market weight, fluctuating between the 4th and 5th largest.  A summary of those sector weightings is best captured in the chart from Standard & Poor's (NYSEARCA:SPY) below. 

Energy Sector Weightings

The S&P 500's energy sector as of 11/12/12 is made up of 45 energy companies and weighted based on market capitalization (stock price x shares outstanding).  But, if just the top 10 energy companies out of the entire 45 are isolated, a full 62% of the XLE's market cap is generated. 

Furthermore, five stocks constitute 49% and just two stocks make up over 35% of the XLE's value. It is actually more concentrated than the often talked about Tech sector!

The spreadsheet captures the breakdown of the energy sector by market cap weighting including the top 10, 5, and two companies in the index.

The Key to the Energy Sector

The chart below shows the top five index constituents along with XLE and shows very similar performance in the largest energy companies. 

Since the June lows, four of the top five companies in the sector, making up 45% of its weighting, are clustered around similar performance.  ExxonMobil (NYSEARCA:XOM), a full 20% of the index, is up 14% compared to the XLE at 13%, and the lone outperformer of the 5.  Chevron Corp (NYSE:CVX) in red, Shlumberger Ltd (NYSE:SLB) in orange, and Conocophillips (NYSE:COP) in blue have all slightly underperformed the index since the June lows. 

Occidental Pete Corp (NYSE:OXY) is the lone laggard down over 1% since the June lows and underperforming the index by 14%.  But, at only 4% of the sector weight, its underperformance is dwarfed almost to irrelevance by the larger constituents.

It's all About Exxon and Chevron

At 35% of the index, Exxon and Chevron are far more important than Schlumberger, Occidental, or Conocophillips combined.  In fact, either one of those two large companies is more important than those next three combined.  Any significant underperformance of Exxon or Chevron would no doubt lead the XLE down in price.

By focusing on just two companies we can get a better understanding of the entire energy sector!

Since the October S&P highs, the energy and financial sectors are holding up their relative strength outperformance.  The energy sector has recently stopped leading the market higher, now performing equally to the S&P 500.  Once it and the financials start to become laggards, we will be more inclined to call the recent market selloff worse than just another dip buying opportunity. 

The ETF Profit Strategy Newsletterevaluates the bullish and bearish potential of the market with a unique approach, along with corresponding target levels and profit strategies.  Relative Strength sector analysis is one strategy we use to help us identify key trend changes in the sectors as well as the broader markets.Follow us on Twitter at ETFguide