With the S&P 500 Index up 15% year-to-date, it is no trivial thing to be “beating the market.” As a general rule, more defensive sectors such as healthcare, utilities and staples are trailing as more economically sensitive sectors benefit from rising, or at least less negative growth expectations.
Not surprisingly, in the current environment of “good enough”, growth investors are reverting to form and favoring technology companies. What is more surprising is the dogged persistence of a less glamorous sector: energy. Year-to-date the U.S. GICS Energy Sector is up 18%, beating the market by roughly 200 basis points (bps). Despite the magnitude of the recent gains, still cheap valuations and an intensifying bull market in oil suggest further upside.
Attractive relative value
I last discussed the sector in early February. At the time I suggested that energy stocks, already significantly above their December lows, were still cheap relative to the broader market. While energy stocks are now up nearly 25% from their Christmas Eve bottom, they remain cheap relative to their history, the market and the price of crude.
Based on price-to-book (P/B) the energy sector is still the second cheapest sector after financials. While valuations have risen from the multi-decade low witnessed last December, the sector still trades at a 49% discount to broader market (see Chart).
In addition, as I highlighted in February the sector also looks cheap relative to the price of oil. If anything, as oil prices have gained the discount has widened. West Texas Intermediate (WTI) crude has risen by roughly 20% during the past two months. At nearly $65/barrel, the historical relationship between oil prices and relative value suggests energy stocks should be trading at a much smaller, 15% discount to the broader market. Put differently: The relative value of the energy sector has never been this cheap with oil above $60/barrel.
Are these prices sustainable?
This obviously raises the question of whether high oil prices are sustainable. While forecasting crude prices is treacherous, particularly given the commodities dependence on OPEC and the vagaries of geopolitics, two factors favor stable prices: the economy and the dollar. While investors should have modest expectations for growth, the U.S. remains stable and there are tentative signs of stabilizing growth in Europe and China. Less economic anxiety removes one of the headwinds to crude prices.
At the same time, while growth is improving it is not so strong, nor inflation so high that the Fed need be concerned. This has led to an abrupt reversal in expectations for monetary policy. With the Fed more likely to take the rest of the year off, the dollar looks less threatening. Easier monetary condition and a flat(ish) dollar create a more supportive environment for energy prices. Again, oil does not need to rip higher, but merely remain in its recent range for energy stocks to realize some of their pent-up value.