Energy Corrects

The energy sector pulled back a bit last week and the decline continued today. This sector is prone to sharp, sudden breakdowns and hasn't had one in several months. The question is whether we are seeing temporary weakness or the beginning of another precipitous drop.

To the extent energy-related commodity prices drive the energy equity sector, the supply/demand picture is increasingly bearish. Crude oil dropped more than 3% today on signs that U.S. gasoline supplies will be adequate to meet summer demand. The recent spike in prices at the pump is largely a result of refinery downtime as equipment was reconfigured to produce the special smog-control blends many states and cities require in the summer. With most of that work now done, the supply pressure should ease somewhat. Positive events overseas, such as the end of an oil-worker strike in Nigeria and a historic meeting between U.S. and Iranian diplomats, also reduced the geopolitical risk premium built into energy prices.

The magnitude of energy's decline so far suggests that the sector is in the midst of a short-term correction. Given the propensity of energy stocks to fall hard and fast, however, we remain cautious. The same advice applies to the utilities sector, which has also pulled back but appears to have found a bottom. Record-setting volume in some utilities ETFs last week may prove to have been a selling climax, clearing the way for renewed upward momentum. Today brought a partial recovery, which was encouraging, but caution is still a good idea with utilities for now.

In the bigger picture, the S&P 500 is still trying to punch through long-term resistance and reach new highs. Continuing sideways consolidation is a positive sign, as it means there is not enough selling pressure to drive the index down significantly. Meanwhile small caps are picking up a little strength, which if it persists would be very helpful in driving the broad market benchmarks higher. We expect an interesting summer.