Hedge Against Two Huge Risks The Fed Can't Control

There are several things that the Fed cannot control, and one of them is the geopolitical backdrop that we all face at any given time. Right now, that backdrop is a dangerous one, and it's getting more so every day in the Middle East.

Ukraine is still a concern as well, but there is no question that the "contained escalation" that has existed for almost a year now in the Middle East is becoming very strained, and the markets are not pricing in these risks at all.

I believe there is one good way for investors to protect themselves and still take advantage of any further gains in the broad market this year. 

The geopolitical situation around the globe right now is a precarious one. The war between Ukraine and Russia has been going on for some time now. However, if Ukraine were to start shooting NATO-provided long-range missiles deep into Russia, the escalation that could result is almost too dangerous to contemplate.

Another big concern for right now is the situation in the Middle East. Of course, I’ve been harping on this issue for many months, but I don't feel like the "boy who cried wolf" because I’ve never said that this conflict was on the immediate brink of becoming a full regional war. I’ve merely tried to keep it on people's radar screen and said that it is something that could (and probably WILL) become a very big problem for the global stock markets at some point in the future.

Well, the pace at which this situation is escalating is now growing. No, I’m still not saying that a much bigger war is imminent, but there is no question that the situation is getting much worse, much more quickly, than it had been before. Thus, although I think that it’s unlikely to unravel before the U.S. election, anything is possible. There is little question in my mind that it will have a very negative impact on the global economy and global markets. A full regional war in the Middle East will cause the supply of crude oil to shrink significantly around the world, because the flow through the Strait of Hormuz and the Red Sea would become seriously compromised. 

For me, I keep hearing and reading opinions about what the goals are for this conflict, and I think those opinions are wrong. Actually, the goals that I keep hearing and reading about are legitimate ones, they're just not the most important goals for Israel. Yes, Israel does want to eradicate Hamas, as they see them as a threat to the safety of its citizens. They do also want to diminish (or destroy) Hezbollah's ability to fire rockets into the northern part of their country. However, it is my belief that Israel’s ultimate goal is to keep Iran from becoming a nuclear power. Therefore, I strongly believe that the odds that this will become a full regional conflict are much higher than the global stock markets are pricing-in right now. 

The problem for a lot of investors, especially for professional investors, is that the market is having another great year, and so FOMO is having an impact on how they are acting right now. However, I believe that there is one way investors can hedge some of these geopolitical risks and not hurt their performance over the rest of this year!

After a multi-month period of underperformance, I believe that energy stocks will provide a nice win/win opportunity for investors.

Since the energy sector has suffered through almost 5 months of underperformance, it is becoming quite cheap again. Also, the XLE energy stock ETF and the XOP oil and gas E&P stock ETF are coming off oversold conditions. Therefore, this sector is looking quite enticing again.

In other words, although investors can raise some cash to protect against these geopolitical threats, they can also add to their energy exposure as a hedge. With the sector much cheaper than it was 6-7 months ago, and oil unlikely to decline a lot due to the conflict in the Middle East, the downside to having a heavier weighting in the energy stocks should be limited. At the same time, if the situation does boil over, these stocks should outperform.

I must admit that after the strong bounces in these two ETFs over the past week and a half, we could see them take a breather soon. However, when a sector gets beaten down enough that it becomes both cheap and oversold, it tends to provide a great opportunity to make some very nice gains over the intermediate term, with limited downside risk. 

What I’m saying is that since the energy group is undervalued and oversold, it should be about to outperform the market over the rest of the year, even if the Middle East avoids becoming a much bigger problem until next year. However, if it does become a wider crisis, the energy stocks should outperform in a significant way.

Of course, if the entire market gets hit in a major way due to a major crisis, the energy stocks will go down as well. However, they will not go down as much. So, that will still help the performance of professional investors. 

I’ve provided the charts on both the XLE and XOP ETFs below:

For the XLE, it has bounced off its trend-line going back over two years. I'd also note that the weekly MACD chart is starting to curl higher. If the group can advance enough over the next week or two to give it a positive cross, it's going to be very bullish for the sector, given how bullish that kind of move has been in the past. 

As you can see from the second chart, the XOP is seeing almost exactly the same kind of action.

As for some specific stocks, I’m talking about these several different names in my chatroom on a daily basis. Again, I understand why investors don't want to become too cautious right now on the broad stock market, but I just think that the energy sector will help them going forward. The sector should be able to keep up with the market, and it should outperform in a big way if the situation in the Middle East does blow up sooner, rather than later. 

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