MKM Partners and Fundstrat chart analysts told clients that energy and financial stocks have the strongest charts in the market and that their breakouts are likely to continue.
“Friday’s breakout on the Dow JonesEnergy sector suggests another +15 percent upside for the index, which means plenty of upside for the constituents,” said MKM Partners chief market technician JC O’Hara. “We continue to recommend that you invest in your favorite Energy company.”
The major energy ETFs, such as the Energy Select Sector SPDR ETF and the SPDR S&P Oil & Gas Exploration ETF, saw significant breakouts last week as oil prices rose. The ETFs have gained more than 8% in October, while the Dow Joneshas gained less than 2%. WTI Crude prices surpassed $81 per barrel earlier Monday, as the energy crisis gripping major economies shows no signs of abating despite an increase in economic activity and limited supply from major producers.
“There is a case to be made that both ETFs can return to their 2018 levels.” “The Dollar and WTI Crude have a longer-term inverse correlation,” O’Hara said.
Fundstrat also informed clients that energy will remain a key focus as the XLE and crude prices break out to their highest levels in 2021.
“Additional strength appears likely to 58-58.50 in XLE, with areas near 61 providing strong resistance,” Fundstrat told clients.
Another area attracting technical analysts’ attention is the financial sector.
Last week, the Financial Select Sector SPDR ETF outperformed the Dow Jonesand reached a 52-week high. This year, the financial ETF is up more than 32%, roughly double the return of the broader market.
“There are numerous Financial charts that show strong momentum from the November lows to the March 2021 highs.” Financials consolidated for 6 months to erase overbought conditions and digest those strong gains,” O’Hara wrote.
“They’ve started to break out now. Financials account for nearly 16% of the Russell 2000. We believe that if Financials break out, the smaller cap Russell 2000 Index will follow suit. Bullish investors require confirmation, or at the very least participation, from small caps,” he added.
According to Fundstrat, many investment bank gains have stalled, while commercial and regional banks have outperformed.
This week marks the start of earnings season, with major US banks leading the way. The outcomes may have an impact on whether the overall sector remains strong.
Beware of the overall market?
Despite being bullish on energy and financial stocks, both analysts are currently bearish on the market as a whole.
“Structurally, the US Market indices still have work to do before trends turn positive,” Fundstrat told clients.
According to the same analysts, the major averages have all risen to test meaningful resistance at the downtrend that began in early September.
“It’s thought that this should be important heading into next week,” the Fundstrat analyst added. “Trends remain short-term negative and it’s still difficult technically to have a positive bias until the S&P gets above 4421 at a minimum (while above 4465 for more conviction).”
The Dow Joneshad a rough September, and according to O’Hara, market internals were much weaker during this decline than during the other minor pullbacks this year.
“This position of weakness makes the ‘Buy the Dip’ much more difficult to pull off this time,” O’Hara added. “We are more comfortable buying pullbacks within uptrends rather than trying to buy stock in a Strong Down Trend.” According to our calculations, 37% of the S&P 1500 is currently in a strong downtrend. Two out of every three stocks are in a downward trend. This ‘buy the dip’ momentum is not easy to maintain.”
The stagflation effect
Stagflation is a rare period of low growth and rising prices, first identified in the 1970s. The one-of-a-kind phenomenon has resurfaced on the radars of investors, as many fear that the surge in post-pandemic activity will begin to slow, while inflation will accelerate to high levels with ultra-easy monetary policy still in place.
According to Goldman, during the past 60 years of stagflation, falling profit margins and rising interest rates reduced the median quarterly Dow Jonesreal total return to minus 2.1 percent, down from a 2.5 percent median gain for all quarters.
To be sure, the firm reiterated that stagflation is not the firm’s base case, but it acknowledged that clients should be aware of it.
“If inflation remains high alongside a weakening economic growth outlook, firms with strong pricing power should be best positioned to maintain profit margins despite slowing revenue growth and rising input costs,” said David Kostin, head of U.S. equity strategy at Goldman Sachs.
The Wall Street firm screened Russell 1000 stocks with high and stable gross margins relative to sector peers for stocks with high pricing power. Meanwhile, their gross margins have not recently declined.
According to Goldman, a basket of stocks with high pricing power outperformed a basket of stocks with low pricing power by 15 percentage points from June to August, but has lagged by 11 percentage points in recent weeks.
Tapestry, PVH, Under Armour, and Colgate-Palmotive are among the high-priced power stocks. Adobe, Oracle, Synopsys, and Workday are among the technology companies on the list.
Goldman recently lowered its forecast for U.S. economic growth, citing the expiration of fiscal support from Congress as well as a slower-than-expected recovery in consumer spending. The firm reduced its 2022 GDP annual growth forecast to 4% from 4.4 percent, and reduced its 2021 forecast to 5.6 percent from 5.7 percent.
However, the firm believes that inflation will peak in the coming months, reassuring investors and helping to lift the Dow Jonesto 4,700 by the end of 2021. The end-of-year target represents a 7% increase over Friday’s close of 4,391.34.
“We believe that approximately US$120-160tn will be required just to de-carbonize the energy system,” the analysts, led by Supriya Subramanian, wrote in a research note published on September 30. “However, energy transition and the path to net zero will require more than just the energy sector to be involved.” The global economy as a whole will need to be retooled.”
According to the analysts, the electrical equipment sector is “likely to be one of the largest beneficiaries of the ongoing energy transition.” Siemens Energy, for its transition to renewable energy; Schneider Electric, which is set to benefit from the building renovation sector; hydro power company Andritz; and Wartsila, “one of the global leaders in industrial scale battery storage,” are among UBS’s “most preferred” stock picks in the sector.
“Electrification of the economy (both in terms of power supply and end-use) is expected to be a key trend in the coming years.” Apart from increased investments in clean energy generation, we anticipate a significant increase in investments in the expansion and modernization of electricity networks,” the analysts said.
Several companies in the heating, ventilation, and air-conditioning business, including Johnson Controls and SPX Corp., are set to benefit from the electrical equipment and multi-industry (known as EEMI) sector in the United States.
According to UBS, power company Eaton will be a “strong beneficiary” of grid and electric vehicle investments. It also likes GE, stating that its wind and electricity grid businesses, as well as its hydrogen-fueled gas turbines, are likely to benefit. “However, depending on future policies and the role of gas, there could be a headwind for this business in the long run,” the analysts cautioned.
“We also expect a corresponding increase in investment in end-use electrification, with increased spending on EV batteries, heat pumps, and electricity-based industrial equipment,” they added.
The UBS picks mentioned are all rated as buy by the bank.
According to UBS, electrification and electricity systems will need to account for 59 percent of fuel used to achieve net-zero carbon emissions by 2050, up from around 40 percent in 2020, far outweighing other types of fuel like hydrogen and bioenergy.
The UBS note comes at a critical juncture in which policymakers and businesses are under intense pressure to meet the demands of the climate emergency.
The International Energy Agency stated in May that achieving net-zero emissions in the energy sector by 2050 would necessitate a “unprecedented transformation of how energy is produced, transported, and used globally.” It went on to say that current pledges fall far short of what is required to reach the netzero goal.
The burning of fossil fuels, such as oil and gas, is the primary cause of the climate crisis, and despite a growing emphasis on a transition away from these, the world’s reliance on these is expected to worsen in the coming decades.