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Energy Pessimism Makes for a Contrarian Buy

The energy sector as a whole hasn’t been doing great.

Now, I’m not talking about the energy business. America’s in the midst of an energy boom. Global rig counts are strong, and oil prices have nearly tripled since falling to about $30 a barrel in 2009.

But energy stocks have still lagged the market… substantially.

Setting aside all the fundamental opportunities in the energy sector – like the massive infrastructure needed to shift to natural gas and the increasing demand from a growing global economy – the cyclical nature of the market dictates that energy stocks play catch-up for the next few months.

Just take a look at the chart below, and you can plainly see that – since March – energy stocks have decoupled from the market as a whole.

This stems largely from a decrease in the valuation on energy stocks. The price-to-earnings multiple on the energy sector has diverged from the market in a similar way. Energy stocks now trade at 11.3 times earnings, compared to 14.2 times for the S&P 500.

This lagging performance and cheap valuation alone make for a compelling contrarian play, but there’s even more of reason to believe energy stocks will turn around…

Indeed, early returns from earnings season, and the expectations of analysts moving forward, suggest we’re about to see a number of positive surprises boost the market.

Here’s why…

Right now, analysts are pessimistic about energy fundamentals. As a result, earnings per share for energy companies yet to report are expected to decline by 14% on average. But the thing about Wall Street analysts is that they’re always the most pessimistic (and alternatively, the most optimistic) at exactly the wrong time.

That’s already evident in the results we’ve seen.

Of the seven energy companies that have reported earnings, four have beaten analysts’ estimates for earnings per share. So early signs suggest this could be a turning point.

On top of that, trading volume for energy stocks dropped 25% over the last year – another signal of a turnaround.

The bottom line: While energy prices fluctuate, stocks still tend to track the market as a whole. So simply betting on a return to average performance over the next few months looks like a winning strategy here.

To put an even finer point on it, we expect oil and gas servicers to outperform producers over the same period. We’ll have more on that soon.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk