I Built a 2.5X Better Energy Basket… Check It Out

By Michael Salvatore, Editor, TradeSmith Daily

In This Digest:

Are you flat for the year?
A new, 2.5x better way to “own the energy sector”…
We’re designing new systems, and we want to know what you think…
Our TradeSmithGPT launch event is two hours away – sign up automatically right here…

The market’s been on a wild ride to nowhere this year…

Just look at this year-to-date chart of the S&P 500. Almost halfway through the year, and after all the drama of tariffs, DOGE, the tax bill, old wars trying to end and new ones trying to start… Stocks are about 3% higher from where we started:

There’s still money to be made. We’ve seen wild moves up and down in the benchmarks that are well worth trading.

But if you’re a buy-and-hope index investor, you’re probably a bit grumpy about this year.

Good news: There’s still lots of ways to make money in this environment.

It just isn’t as easy as it’s been since the dawn of the new bull in early 2023.

You have to open your mind to one of two new methods:

Pick great stocks that weather any storm. Plenty of stocks, even large-cap stocks, are up more than the market this year. Palantir Technologies (PLTR), Seagate Technology Holdings (STX), Micron Technology (MU), and Howmet Aerospace (HWM) are just a few off the top of my head and there are many more.
Trade the moves up and down. If you understand volatility, you realize that this year has been an incredible year for trading. And if you want to put the odds on your side as a trader, you’ll want to read to the end of today’s Digest.

We’ll talk about both today, starting with a simple way to find great stocks in a sector getting a ton of attention right now…

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The energy sector is not what you’d typically call exciting…

That is, until war drums start beating in the Middle East.

As we covered over the past week, even the mildest hints of Middle East conflicts tend to shock the price of oil higher. Many oil-producing countries – Iran, the United Arab Emirates, Kuwait, Qatar, and more – line the Persian Gulf. Whenever bombs start dropping in this part of the world, energy prices gain a significant risk premium.

The recent conflict in Iran reflects this. After the first bomb dropped on June 13, oil prices shot up 20%. Now, with the conflict appearing to have died down, oil prices are back to where they were before. Another roundtrip:

Nonetheless, if you wanted exposure to higher oil prices after the bombs dropped, you probably thought to buy the Energy Select Sector SPDR ETF (XLE)…

Only that wound up being a bad trade. Even worse than buying oil futures.

XLE (blue line below) barely moved in response to the conflict. It’s underperformed its two key baseline commodities, oil and natural gas. And it’s also flat from June 10:

And now that you mention it, XLE is flat from November 2022. Its last big push was earlier in 2022, so all in all it’s up about 30% in three years:

It’s not like there are no good energy stocks. There are plenty of dividend-paying, even large-cap energy stocks that have outperformed this ETF in the last three years. All 10 of the stocks below have bested the XLE benchmark, some more than others:

So if we know there are great energy stocks out there, our task becomes to find the next market leaders.

My job at TradeSmith is to find ways to help you make money. One way I love doing that is by building simple but effective systems.

Noting the disappointing performance in XLE this week, I had an idea.

I set out to build a simple portfolio-rotation strategy that would selectively buy a group of five U.S.-listed energy stocks, position-size them according to the past year of volatility, and then update that portfolio once per month.

Following this strategy would take just a few minutes of work per week. Most weeks you’re simply rebalancing the positions, and some weeks – maybe a few times per year – you’re selling positions entirely to make room for new ones.

The way I selected the group uses three key metrics:

Free Cash Flow Yield – A measure of free cash flow as a ratio against a company’s market value. For this strategy, we want stocks with a Free Cash Flow Yield of 10% or more.
Average Five-Year Dividend Yield – We only want to own stocks with average dividend yields greater than 1% over the past five years.
Sales per Employee – This is a rather obscure but powerful fundamental metric that measures a company’s sales against the number of employees it holds. For our purposes, we want companies with Sales per Employee higher than the 12-month trailing industry average.

You only own the best of the top 50% of U.S.-listed energy stocks based on these parameters. And here are the results of a backtest going back 20 years:

Now tell me – with a near 10X return on your money in 20 years vs. just over 4X by holding XLE, is the few minutes of work per week worth it to you?

I would say it is.

Now, some caveats to this. Clearly, this is a more volatile strategy. The drawdown from 2017 to 2020 is particularly nasty. If you want that long-run outperformance, it means continuing to buy in periods where the strategy doesn’t work. (I’ve tried adding hedges – it just neuters the long-run returns.)

Also note that this strategy, while recently making new highs, has also been flat for a few years. It outperforms strongly in energy bull markets, but largely falls victim to sideways action just the same.

It’s also worth noting that the stocks that tend to fall in this category are small- and mid- caps – not that that’s a bad thing, they just tend to be more volatile.

Here are the current portfolio holdings and their market caps, for example.

Finally, this strategy is a work in progress. We’re still looking at ways to optimize the returns without making it overly complicated to trade. So, the book isn’t closed on this particular idea just yet.

Now, I share this idea with you for two reasons.

For one, portfolio rotation strategies are of great interest to me and a lot of us here at TradeSmith.

But we want to know… Is this something you want to see more of? Would you follow a strategy like this? What sectors do you want to see us apply this idea to? Write us at feedback@TradeSmithDaily.com and we’ll get to work in the lab.

And for two, it’s important for you to understand just how powerful it can be to get choosy with your investments.

ETFs let you own a whole basket of stocks very easily.

But when you do that, you tend to own large, slow movers… with little restriction on what’s in that basket other than size.

What these sector plays are really good for is trading…

Comstock Resources (CRK) is one stock that, admittedly, you won’t see on my list above because it doesn’t pay a dividend.

But in our new AI-based trading system we’ve nicknamed TradeSmithGPT, its “profit window” opened up right on June 13. That entry was good for a 20% pop in five trading days:

This stock not only outperformed XLE and oil prices, it’s held onto its gains. That’s significant.

And we were able to spot it because of TradeSmithGPT, our new Large Number Model (LNM).

We’re used to AIs operating by essentially guessing the next best possible word in any given sequence.

The problem with that, especially when you’re using it to trade, is they have to convert numbers to words, try and guess the next word, then convert back to numbers. It’s inefficient and leads to errors.

The model that TradeSmithGPT used to find setups like CRK just works with numbers… Meaning it can do a lot more, and more effectively, in the same amount of time.

That’s why we call this an LNM rather than your traditional “Large Language Model” (LLM).

And the efficiency I’m talking about here makes it a much more powerful way to find trade ideas.

Speaking of ideas – while there’s no way to know for sure what the headlines will bring on July 1, we do know that TradeSmithGPT will be bringing you its three top trades on that date.

Between now and then, it’ll be working to adapt to new conditions as they arise. Day in, day out, it’s teaching itself. That’s what’s so revolutionary, setting AI apart from regular old software.

And in the meantime, you can click here to unlock a free preview of TradeSmithGPT ahead of our world premiere webinar coming up shortly at 10 a.m. Eastern. After that, you’ll have an opportunity to get on the list for those trades. See you there.

I Built a 2.5X Better Energy Basket… Check It Out