Elliptical Research Contribution 2008.4:
|The After Party for Alternative Energy May Have Just Begun
According to the Financial Principle of Relativity
(or, Too Late to the Oil Party? Consider an Alternative. Part 2)
Timothy D. Kailing
27 July 2008
Occasionally, one gets it right. In my market comment last month ("Too Late to the Oil Party? Consider an
Alternative"), I remarked: "though I am a long-term bull on energy, oil has already more than tripled in the past
four years. In my view, after this move, the probability of major price corrections and volatility is currently very
high." While I was on vacation for the first three weeks of July, I was very glad to be out of all investments tightly
correlated to conventional energy, after happily riding them for several years.
However, the alternative energy sector -- which I believe is due for a major positive move in the medium to long
term -- has not exactly lit things up this last month. Most of the major stocks are flat to down, with PBW, the
PowerShares WilderHill Clean Energy ETF on which I focused in my analysis, down just over 10% in that time.
But this is all in absolute terms, and when it comes to markets, I believe in a financial principle of relativity: all
performance is relative. And when you look at the relative performance of PBW and the oil ETF USO it looks like,
in relative terms, the party for alternatives may have already begun.
Financial Relativity: The Special Relativity of Oil and Alternative Energy
The chart below is a depiction of the relative performance of PBW versus USO for the last year:
During the last two weeks, where the arrow indicates, a major linear trend in the relative price of PBW and USO
looks to have statistically broken. For the previous six months, alternative energy consistently lagged
conventional energy, but during the recent pullback in oil, this relationship has broken out of its statistical
"channel". Whether this is a mere "test" or the beginning of a true reversal is yet to be seen, of course. But for a
long-term investor confident that alternative energy has the fundamentals of supply and demand on its side, it is
a sign that the wait for a bullish move may soon be over.
Beyond market fundamentals, I think that the upcoming election may provide a catalyst for capital flow towards
alternative energy equities. Unless oil prices really tank over the next few months -- back into the sub-100 dollar
range per barrel, which I don't expect -- I believe it's quite likely that Obama and McCain will get into an escalating
battle about who is more supportive of alternative energy. This sort of attention would provide additional support
for the sector and help it to break out of its six-month trend of underperformance relative to conventionals.
The most direct way to apply the financial principle of relativity is through pair trading, or through more complex
variations on the same theme. Properly executed, these strategies can allow one to play the relative
performance of alternative energy versus oil, for example, while remaining agnostic regarding the absolute price
Abstraction and its Discontents
It's vitally important to come up with simple visual representations when you delve into the realm of even basic
abstractions like relative performance strategies. Any responsible quant knows that while useful analyses get
multidimensional and abstract pretty quickly and naturally, you should never surrender entirely to the abstraction
and trust it without struggling for intuitive understanding. In the map of the financial world, going that direction --
into quantitative la-la land -- leads to wrecks like Long Term Capital Management and dear old Enron. The
physicist Richard Feynman once attempted to explain a point of quantum mechanics at the freshman level and
said, "I couldn't do it. I couldn't reduce it to the freshman level. That means we really don't understand it." Many
financial quants forget this, and instead embrace "the smartest guy in the room" pretensions, flaunting and even
exagerating abstraction because they think it makes them look smart.
I'm not the smartest guy in the room, I'm a monkey evolved for picking fruit and avoiding sabre-toothed cats. As a
visual beast, I like to visualize abstract ideas whenever possible. While I am certainly not a classical chartist, like
many market participants I find that candle charts and their variants are useful tools to visualize market patterns.
They are nicely balanced between providing a lot of relevant information while still being intuitive and simple. The
relative movement chart of PBW and USO above is a "shadowless" variant of the traditional candle chart, with up
days (close > open) in white and down days (close < open) in black; it efficiently shows the recent increase of
buying interest in alternative energy relative to oil.
General Relativity in the Markets
For any reasonably-sophisticated market participant, this sort of relative performance analysis is quite generally
useful to have in your bag of tricks. In my quantitative financial modeling, I find it interesting how many
reasonably-persistent linear relationships appear when one looks at the relative performance of market sectors,
for example. Such simple relationships occur far more often in relative terms than in absolute terms. So the
financial principle of relativity is special not only to alternative energy and oil, but is indeed quite general.
In fact, if one takes a thoroughly relative view of markets, bull markets and bear markets become almost
subjective fallacies. In nautical terms, what matters is not the ebb and flow of the tide, but your hull speed
through it. In the long run, that is what counts. The tide will eventually turn. In market terms, during the ebb and
flow of the markets, losing less during bear markets is just as good as gaining more during bull markets, even
though it seldom feels as good. (This is wherein lies the truth of the old adage: "You make the most money in
bear markets. You just don't realize it at the time.") In more general terms, in a limited and competitive world your
economic position depends not on how much money you have, but in how much money you have relative to
those with whom you compete. Take it from a fruit-eating monkey who dreams in equations.
As in my market comment a month ago, for this analysis I use PBW, the PowerShares WilderHill Clean Energy
ETF, as a proxy for alternative energy, but there are a number of analogues which are fairly closely correlated
with PBW. These include the PowerShares WilderHill Progressive Energy ETF (PUW), PowerShares Cleantech
ETF (PZD), and the Market Vectors Global Alternative Energy ETF (GEX). There are, of course, many major
individual equities in the alternative energy space, such as Evergreen Solar (ESLR), First Solar (FSLR), JA Solar
(JASO), Energy Conversion Devices (ENER), Suntech Power (STP), and Trina Solar (TSL); although individual
equities in a rapidly expanding industry tend to be very volatile, and are not for the faint of heart.
Disclosure: I eat my own cooking, as they say. I am currently (as of late July 2008) long alternative energy,
through positions in the PowerShares WilderHill Clean Energy ETF (ticker PBW).
Copyright © 2008 Timothy D. Kailing