The Energy Sector SPDR (XLE) is an exchange-traded fund designed to track the performance of the S&P Energy Sector Index. With the enormous surge in oil prices this past year, XLE has become the most actively traded sector index on the market (excluding HOLDRS). XLE's average daily volume was more than 2.2 million shares per day in August and has averaged over 1.4 million shares each day this year. This compares with an average daily volume of just 422,000 shares in 2003.

The Energy Sector SPDR is not a very well diversified ETF. The fund, which accounts for just under 7% of the value of the S&P 500, includes 27 companies. However, 68.75% of the fund's value resides in its ten largest holdings. The top two spots, Exxon Mobil (XOM, $47.37) and ChevronTexaco (CVX, $50.03), account for 21.84% at 15.45% respectively (data as of September 3, 2004). 

Options in XLE are available, but are rather illiquid. Options in XOM and CVX are far better traded. The correlation between the price of Exxon Mobil and XLE is nearly 85%. The correlation between XLE, CVX and XOM combined is above 88%. This means that you can effectively hedge your XLE exposure via options in CVX and XOM. The very high weighting of these two issues also means that you need to take special account of news and the technical situation for each of these stocks when trading XLE.

In the past, energy stocks have made excellent defensive plays. XLE did not top until May 2001, and lost much less during the 2000-2003 bear market, top to bottom, than did the overall S&P 500. Its dividend yield is normally fairly high, but the fund's strong gains this year have left its yield close to the S&P 500 norm (XLE sports an annual dividend yield of about +1.5%). With XLE near record highs, it is unlikely to make a particularly good choice as a defensive sector if stocks turn lower from their mid-2004 levels.

Although most of XLE's component stocks are involved heavily in the oil patch, oil prices are not highly correlated with XLE (near 10%). Recently, oil has appeared to show a leading relationship to XLE. That is, turns in the price of oil have preceded turns in the price of XLE. For example, oil hit a new high in mid-August and has fallen fairly sharply since then. However, XLE made a new high more than two weeks after that.

There may be several reasons as to why oil and XLE do not show a very high correlation. Some of these include:

• Many of the Energy SPDR's component stocks are highly diversified. They not only operate in the oil patch, but many are also involved with chemicals and even consumer products. 
• Although oil prices are economically sensitive, the changing nature of demand for the product, due to the growth of China and India, has altered the way oil is priced. XLE is tied to the expected profitability of its component companies, which may only react in a delayed manner to changes in oil prices.
• Inventory levels also affect the profitability of XLE's component stocks.  If inventories are already high, at least for derivative products such as gasoline, then the effect of a change in the price of crude oil may be delayed on the price of oil stocks.

HOW TO MAKE MONEY IN XLE THIS YEAR
XLE was showing substantial momentum divergences as of early September 2004. However, my analysis indicates that the fund can still trade higher. I expect the fund to reach $35-$36 before a large drop (to about $28 or even $25) starts. XLE needs to remain an overweight in any portfolio.

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