'Energy stocks have never offered such value,' Morgan Stanley says
U.S. stocks have been in a strong uptrend in 2017, hitting dozens of records, but they achieved this feat without the contribution of a major sector energy, which has sharply lagged behind the broader market for years. That could be about to change.
While energy (XLE) remains the worst-performing sector of 2017--down nearly 12%, the only S&P 500 sector to be negative on the year--it has shown a pronounced rebound lately. It is up 5.4% over the month of September, by far the top-performing sector over that period. Crude oil is up 6.8% thus far this month, but down 6.1% for 2017.
The sector--as measured by the Energy Select Sector SPDR ETF, the most widely used exchange-traded fund that tracks the industry--has traded below its 50-day moving average for much of 2017, with only rare and brief breaks above that level, which is often seen as a gauge for short-term momentum. It solidly broke above it on Sept. 11, however, and has remained there ever since.
With the recent price action "we are even more convinced an important turn is happening," Morgan Stanley wrote in a note to clients. "The relative and absolute price moves for the sector have definitively broken their well-defined downtrends from last year."
The energy-sector ETF has seen inflows of $703.4 million over the past month, according to FactSet data, enough to turn its year-to-date flows positive. (About $588 million has come into the fund this year.) Among sector funds, only consumer staples have seen higher inflows over the past month, at $1.3 billion.
Currently, the energy sector comprises 5.94% of the market weight of the S&P 500, a multiyear low. Last year it represented 7.56% of the S&P, while it was 10.28% in 2013. (The most heavily weighted sector in the S&P 500 is technology, which accounts for 23.36%, according to Standard & Poor's data.)
Energy stocks are highly correlated to commodity prices, particularly crude oil, which remains down about 50% from a peak hit in 2014, although it has nearly doubled off a low hit in early 2016. A weak U.S. dollar this year has made oil even cheaper for international buyers, further stoking demand. "Global energy demand has surprised even the most bullish forecasts year to date and that is expected to continue given the synchronous global economic recovery," Morgan Stanley wrote.
Despite that, excessive supply for crude, along with lower demand over the past several years--due to both stalling economic growth in some regions over the period, as well as increased adoption of other fuel sources, like natural gas and alternative energies--has been a persistent drag on the sector, which has sharply underperformed the market for the past few years, as seen in the below chart from FactSet.
The sector should be volatile throughout the rest of the year, particularly ahead of the November meeting by the Organization of the Petroleum Exporting Countries. Morgan Stanley also noted that the sector would continue to face competitive pressures from new energy sources, but that "these are very long-term trends and oil will likely go through cyclical peaks and valleys as supply and demand periodically gets out of whack." Meanwhile, "last year's low in crude oil was likely THE low for this cycle," meaning the sector is well positioned given current trends, in the investment bank's view.
The sector is expected to more than double its profit in the third-quarter reporting season, with earnings growth of 108.8%. Of the overall S&P 500's expected 4.5% earnings growth rate, energy is expected to contribute 1.8% of that. This is by far the fastest growth rate of any S&P 500 sector (tech, in second place, is seen delivering growth of 8.1%, and contributing 1.6% to overall profit growth), although it principally reflects easy improvement over weakness in 2016.
"With earnings expectations now more realistic and achievable, energy stocks have a good chance of resuming their primary uptrend particularly given the very low levels of ownership."
Also contributing to the firm's bullish view is the sector's fundamentals, particularly price-to-book calculations--a measure of valuation. "Energy stocks have never offered such value relative to the broader market on a Price/Book basis," it wrote, as seen in the following chart. (While the line is slightly above a low hit early last year, Morgan Stanley still sees it as offering more value now given "much lower financial distress in the sector today versus then.")
"In short, energy stocks have never offered such value relative to the broader market on a Price/Book basis," it wrote.
(END) Dow Jones Newswires
September 20, 2017 16:50 ET (20:50 GMT)