One of the least popular sectors last year and last quarter is finally getting the recognition it deserves, according to analysts at RBC Capital Markets.
The energy sector was down 5.9% during the first quarter of this year, the worst performance among 11 main industries of the S&P 500
according to FactSet data. The broader S&P 500 fell 1.2% during the first three months of the year.
In 2017, when the broader market’s total return was 22%, the energy sector
declined 1%. But over the past month, the sector rallied more than 7%, compared with a 1.7% decline in the broader market.
Higher oil prices and improving profitability of energy companies is just one of the many reasons for being bullish on the sector.
are up nearly 10% since the start of the year and are up 26% over the past 12 months.
That dynamic has helped support the ‘overweight’ position on the energy sector, maintained by Lori Calvasina, head of U.S. equity strategy, since January.
Calvasina says the energy sector has been performing more in sync with rising oil prices of late, something that she expected to persist in the near term, which puts the group in prime position to outperform.
Meanwhile, estimates for earnings and revenues aren’t just improving, they are improving at a rapid clip.
“While most sectors have seen an improvement in earnings per share estimate revisions among sell-side analysts this year, Energy is the only one that has seen a meaningful increase in revenue growth expectations so far this year, which we think is the best way to gauge how assumptions for underlying fundamentals have been trending,” Calvasina wrote in a note.
Over the past month, energy has been the best performer among the S&P 500 sectors, rising more than 7%. Such performance is attracting flows into energy ETFs, which had been negative in January and February.
On a macro level, energy shares tend to outperform the broader market when inflation expectations are rising, which appears to be the case at present.
Energy stocks also tend to outperform amid geopolitical tensions, especially those centered on in the Middle East, which can drive fears of supply disruptions in the oil-rich region. The U.S.-led airstrikes against Syria late last Friday helped to push prices in the energy sector sharply higher, along with U.S. sanctions against major oil producer Russia.
Still, Calvasina isn’t worried about elevated valuations. “Energy doesn’t look undervalued relative to the S&P 500 on forward price-to-earnings ratio, but valuations have improved dramatically on this basis,” she wrote.
The energy sector’s forward 12-month price-to-earnings ratio is at 20.2 times, while the S&P 500 forward P/E is at 16.4, according to FactSet.
Nicholas Colas, co-founder at DataTrek, market research firm, has another reason for giving energy sector a higher consideration.
“There aren’t many places to lower portfolio volatility in a sensible way, but Energy is the best bet here,” Colas wrote in a note to investors.
“The fundamental case for the group is reasonable assuming modestly higher commodity prices over the balance of the year. Middle East geopolitics actually gives the sector a tailwind there, unlike any other industry in the S&P 500. Lastly, the group is neither sensitive to interest rates nor a large enough piece of the index (just 6% weighting) to be predestined to decline in a market swoon,” Colas wrote.
But there risks for the sector. Notably, a stronger U.S. dollar
which most commodities are priced in, could easily spoil this picture as a rise in a dollar has been negatively correlated with the prices of energy stocks.