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Oil stocks are setting up for a massive short squeeze

Lawrence Lewitinn
Lawrence Lewitinn
Talking Numbers

Could energy stocks be so bad they might actually be good?

That appears to be the consensus among some traders as bearish bets against the sector continue to mount. According to data compiled by Bespoke Investment Group, short interest in the S&P 500’s energy sector stocks is fast approaching 10 percent of their total float, hitting levels not seen since the financial crisis.

So far, the shorts have done quite well for themselves. The ETF tracking the energy sector (trading under the symbol XLE) is down 16 percent in the last six months, a victim of plunging crude prices.

And if oil begins to stabilize, that could also bring a halt to energy stocks’ decline. In turn, oil shorts may be forced to scramble to buy energy stocks and lead to a classic short squeeze, a phenomenon in which traders are forced to buy back or cover their bearish bets.

“Certainly, if prices calm down, I would expect a short squeeze in the short term,” said Erin Gibbs, equity chief investment officer for S&P Investment Advisory Services. “The high levels of short interest in multiple energy related stocks, funds and ETFs could quickly push short-term prices upward if oil stabilizes.”

But Gibbs, who has over $15 billion in assets under advisory, sees a long-term justification for being negative on the energy sector.

“Valuations are at 10-year highs, really, because we are seeing a massive EPS (earnings per-share) cut,” she said. “They are expected to earn less than half of what they earned last year.”

Gibbs said that the sector now trades at 28 times its forward earnings compared to under 15 times just a couple of months ago. “That makes the broader S&P 500 forward price-to-earnings multiple of 17 times look downright cheap,” she said. “I don’t see any reason for the shorts to be wrong here.”

Yet there are technical reasons for investors to not be so negative on the sector, according to the chart work of Ari Wald, head of technical analysis at Oppenheimer & Co. His company recently upgraded their view on the sector from underweight to market-perform.

“The reason why we’ve become marginally more positive on it is actually because of seasonals,” Wald said. “Going back to 1990, the energy sector has been the best-performing sector in the S&P 500 between the months of February and April. So I think this is a tailwind. I think this providing a floor for the decline."

What is keeping him hesitant on upgrading the sector further is that he finds the XLE’s trend relatively weak compared to the S&P 500. Charting the price of the ETF versus the index shows the XLE still severely underperforming the market.

“My money is just worth too much to me than to buy weak trends,” he said “We like to trade it in the direction of the trend for energy. I think it is going to need to stabilize, really for the rest of the year, until we can make that case. So for now, we’re very comfortable with our market-perform rating.”