What happens when XLE and oil diverge? The energy sector is a bullish factor for the S&P 500.

Our first study looked at how the energy sector’s divergence with the S&P 500 should lead to a small 6% correction for the S&P. We thought the energy sector’s continued weakness would drag the S&P 500 down. It hasn’t so far.
On Saturday, we explained that this divergence has lasted too long (6 months compared to the usual 1-3 month divergence). Hence, perhaps this divergence is no longer a bearish factor (post here).
Oil traders will have noticed something else: the energy sector has been much weaker than oil. The energy sector is weaker on a day-to-day basis and an overall basis.
The first chart is XLE (energy ETF), and the second chart is WTI oil.

Here’s oil:

We examined 8 historical cases in which the XLE fell significantly in the past 6 months while oil was either flat or rising. Surprisingly, this led to positive S&P returns over the next few months.
*We need to separate the bull market cases from the bear market cases. Our model says that as of 2017 we are still in a bull market.
*XLE did not exist before the 1990s.

January 14, 1991

The divergence between oil and XLE became very clear in January 1991. By then, the S&P had completed its significant correction of 1990 and rallied significantly throughout the rest of 1991.

April 2, 1994

Oil and XLE diverged significantly by April 1994. By then, the S&P had completed a small correction. The S&P rallied in a very choppy manner over the next 5 months.

April 4, 1994

The S&P’s significant correction was over by early-April. In addition, oil and XLE had diverged significantly by then. The S&P started to climb out of its significant correction territory over the next 5 months.

September 2, 1998

After oil and XLE diverged, the S&P almost completed its significant correction of 1998. Then the S&P bounced around the bottom before rallying vigorously throughout the rest of 1998 and early-1999.

March 2, 1999

After this divergence, the S&P rallied for 2 months before making a quick and small 7% correction in 1999. There are a lot of similarities between our current case and this historical case.

August 9, 2001

Oil and XLE diverged significantly by August 2001. The S&P got killed throughout the rest of August and September 2001. However, we cannot use this historical case as a comparison because the S&P was in a bear market from 2000-2003. We are in a bull market today.

July 17, 2002

This was another bear market case. But unlike the previous bear market case, this marked the bottom of the S&P’s decline. The S&P rallied over the next month, fell again, but was unable to make a significant new low.

 February 27, 2009

Throughout early-2009, oil was rallying while the S&P and the energy sector were getting crushed. But as we all know, the S&P’s bear market ended in early-March 2009. Then it rallied fiercely for 3 months before a small correction began in June 2009.

Bottom line

We still think that the S&P will make a small correction this year. Perhaps the S&P will first rally and then begin a small correction sometime in July-August this year.

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