Kotok: Sell XLE, Buy DXJ On Lower Oil
Oil prices are in a precipitous downfall that has pulled WTI crude down to five-year lows this year. That downward spiral picked up steam following OPEC’s decision over the Thanksgiving holiday to keep production apace.
To market experts such as Cumberland Advisors’ David Kotok, oil at $65 a barrel suggests the beaten-down energy sector will remain under pressure. Consider that, year-to-date, energy is the worst-performing sector of the S'P 500, sliding nearly 10 percent, while the broad benchmark has tacked on gains of nearly 13 percent.
Funds like the $11.2 billion Energy Select Sector SPDR Fund (XLE | A-95) and the SPDR S'P Oil ' Gas Exploration ' Production ETF (XOP | A-46) continue to slide, as the year-to-date chart below shows:
Chart courtesy of StockCharts.com
Sell XLE, XOP and other energy-related ETFs. That’s Kotok’s No. 1 piece of advice to investors today.
In an interview with ETF.com, he also said that while energy exposure needs to be substantially trimmed, opportunities beckon in other sectors such as consumer discretionary and housing, and more specifically to ETF investors, in countries like Japan and currency-hedged funds like the WisdomTree Japan Hedged Equity Fund (DXJ | B-64).
ETF.com:Broadly speaking, some say this was less of an OPEC decision and more of a Saudi Arabia decision. Does it matter to U.S. investors?
David Kotok: It was all Saudi Arabia. Saudi Arabia made a decision that was really a geopolitical decision. They could slow down U.S. expansion in shale; they could slow down Canadian tar; they could hurt Iran.
They have the staying ability to do whatever they want, and you can see that in their decision to see where things stand six months from now. If I were in Riyadh making the decision, I would have done exactly what the Saudis did, which was to say:“We are going to produce just as we have been. It’s too soon to dramatically react.”
ETF.com:Do you agree with the suggestion that the Saudis’ decision is in line with U.S. interests as far as Russia is concerned? At the end of the day, it hurts Russia the most, so this keeps the heat on Vladimir Putin.
Kotok: I think that’s a reach. Yes, it may be, but that may be a coincidence. My sense is that the Saudis’ decision was made by looking across the Persian Gulf at Iran—the single-biggest thing on their mind. By not doing anything, they weakened their enemy on the other side of that body of water. They also weakened their enemies in the war zone in Iraq and Syria. They are threatened by both.
To them, $60-$70 oil doesn’t make a difference—they have plenty of oil. This whole notion of current budget issues in Saudi Arabia, if it were sustained for many years, would be something. But for a few months or even a year, they made the best decision in their interest. If it helps the U.S. and hurts Putin, that’s a coincidence.
ETF.com:Cheaper oil is ultimately good for the U.S. economy—is that how investors should look at dropping oil prices?
Kotok: There are winner and losers. It’s certainly hurting some sectors in the U.S. For example, a $150,000-a-year job in North Dakota is now threatened. The one-way rising-price structure is now going to have to experience volatility in the opposite direction.
Our view here is that you have to underweight the energy sector, and stay underweight for as long as it takes to play this all out. The ETFs that are representative of the energy sector need to be sold. If that means you take losses, you just have to take the losses. That’s part of this business.
I don’t see a max-underweight energy position changing until there’s a lot more clarity, because we have two things going on at once macroeconomically. On one side, we have the supply curve shift to greater supply worldwide. That shift in a structural context came at the same time the U.S. is in an economic recovery, but demand is not rising rapidly because of our domestic supply, and because of some substitution effect that’s taking place with natural gas versus oil.
On the other side, gasoline prices will be lower in the U.S., and when they’re lower, consumer discretionary benefits and housing benefits. Lower gasoline prices also mean interest rates will be low for longer, there’s no inflationary pressure, and real income in 135 million American households will rise when gasoline prices fall.
There are estimates that say the fall in oil prices from $115 to $65 translates, on an annual basis, to lower energy bills and to a stimulus that’s equal to—or larger than—the entire 2 percent payroll tax cut. That’s remarkable.
ETF.com:How much time would it take to see that type of impact?
Kotok: What we need is to have a change in trend that’s accepted as having a long life structurally, even if not permanent. If gasoline prices go down for a week, nothing changes, but if they go down for a month and the outlook is for them to stay down for six months or more, then a household figures out that it has additional money. That eventually adds to the growth rate of the U.S. economy.
It also adds to growth rates in a place like Japan. A large part of Japan’s imported energy bill is tied to the price of oil. Lower oil prices, as we’ve seen, could give an offset in Japan of 1.5 to 2.0 points in GDP growth rates, and fully offset the tax hike by Prime Minister Abe. This is a very bullish move for currency-hedged ETFs like the WisdomTree Japan Hedged Equity Fund (DXJ | B-64).
Who would have thought that the Saudis’ geopolitical move on oil prices would raise the upside targets for DXJ? DXJ is currently our largest non-U.S. ETF holding, and I never thought I’d turn more bullish on it because of an oil price fall, but here we are.
ETF.com:So the message to U.S. investors is:Sell the Energy Select Sector SPDR Fund (XLE | A-95) , and the SPDR S'P Oil ' Gas Exploration ' Production ETF (XOP | A-46) , and buy DXJ?
Kotok: Yes. Companies that were selling oil at $115 and now are selling at $65 are the losers here. They sell the same barrel of oil, their capital cost is the same, but the price per barrel is down. The winners are the people who are paying them. If the U.S. were 100 percent self-sufficient, than the impact on the U.S. of lower oil prices would be an offset between winners and losers. But because we are still a net importer, lower oil prices are a win for us.
Funds like XLE, XOP, the Market Vectors Oil Services ETF (OIH | A-41)—there are a lot of ETFs in the energy segment. You want to underweight them right now, sell them. But it’s very important to look at specific energy ETFs as well as at the composition of broad-based ETFs.
For example, the RevenueShares Large Cap ETF (RWL |B-87) allocates about 10 percent to oil and gas. That’s higher than the market rate. But it’s even higher in retail, with the third weight in pharma, health care. When we looked at RWL we decided we didn’t have to exit RWL because we own it out of the benefits of rising revenue in retail space, which is now going to get more robust, and out of position in health care. So we will tolerate the overweight in oil and gas because it’s offset. But we don’t want to own XLE.
Again, outside of the U.S., we are very optimistic on DXJ.
ETF.com:Does oil at $65 point to an oil glut globally?
Kotok: I’m not so sure of that. There’s certainly a temporary oil glut, but where the oil market will be one or two years from now is not clear. Geopolitical risk is high in the Middle East—we see it every single day.
If large economies like China become more robust, their consumption will rise more rapidly. If Europe, which is facing zero inflation and suppressed growth rates, could see its stimulus plans spark growth rates from 0 to 1 percent, you are looking at an increase of growth of 1 percent in an economy that’s the size of the U.S. But how it all plays out remains to be seen.
ETF.com:It’s difficult to time these things, if it’s even possible, but is oil at $65 a value play? At what level would you consider oil and energy a good value opportunity?
Kotok: It might be a good value play at these levels. There’s no way to know that for another six months or a year, when you can look back and say:“That was a good entry point.”
I’ll stay underweight energy for now. The short-term volatility in energy prices is something I’ve tracked for half a century, and that volatility is always greater as a shock in either direction than people normally expect. I was in this business when the price of oil was $3 a barrel, and went to $12 in the early 1970s. I can remember volatilities in both directions, and investors usually are ill-equipped to deal with them on a short-term basis.
Longer-term, energy tends to neutralize to trend rates. Now, whether the trend rate in the U.S. is $60 or $70, I don’t know. But it was way too high at $110 and it would be way too low at $40. That’s about as much as you can know today. That would suggest somewhere between $60 and $70 is probably a mean reversion value proposition. The problem with energy prices is that we have mean reversion, but we don’t stay at mean-reversion prices very long. We go through quickly in either direction, and that’s what we are doing right now.
