Until recently, revealing to people that I wrote about and traded in the energy sector invariably provoked the same response. Their jaws would drop, and they would look at me in disbelief, asking whether or not I was completely sane. That was understandable, I guess, if somewhat insulting, and despite the fact that it demonstrated complete ignorance of the difference between trading and investing. After all, energy was a sector that had underperformed the market for a decade or more, and, as recently as a year and a half ago, didn’t Jim Cramer say repeatedly and, of course, loudly that energy was “uninvestable”?
Those of us that maintained throughout that that ultimately rapidly expanding demand for energy and a finite supply of oil and gas, still needed in vast quantities even as the world shifted to renewable energy sources, would result in higher energy stock and commodity prices, can be forgiven a little schadenfreude right now. However, what we should be asking at this point is whether or not we can expect the energy sector’s outperformance to continue.
The answer is yes…for a while, at least.
We are in a weird situation right now, where the market and economic data are sending conflicting signals. Stocks have been trending downwards all year, and as we have seen over the last couple of days, every rally is met by heavy selling. And yet the underlying economic and corporate data remain strong. Yes, GDP contracted last quarter…
Until recently, revealing to people that I wrote about and traded in the energy sector invariably provoked the same response. Their jaws would drop, and they would look at me in disbelief, asking whether or not I was completely sane. That was understandable, I guess, if somewhat insulting, and despite the fact that it demonstrated complete ignorance of the difference between trading and investing. After all, energy was a sector that had underperformed the market for a decade or more, and, as recently as a year and a half ago, didn’t Jim Cramer say repeatedly and, of course, loudly that energy was “uninvestable”?
Those of us that maintained throughout that that ultimately rapidly expanding demand for energy and a finite supply of oil and gas, still needed in vast quantities even as the world shifted to renewable energy sources, would result in higher energy stock and commodity prices, can be forgiven a little schadenfreude right now. However, what we should be asking at this point is whether or not we can expect the energy sector’s outperformance to continue.
The answer is yes…for a while, at least.
We are in a weird situation right now, where the market and economic data are sending conflicting signals. Stocks have been trending downwards all year, and as we have seen over the last couple of days, every rally is met by heavy selling. And yet the underlying economic and corporate data remain strong. Yes, GDP contracted last quarter but that is easily attributable to the Omicron variant of Covid. And other indicators, most notably extremely low unemployment, back up the view that that was a blip, not a trend reversal. Corporate profitability suggests that too, with earnings so far showing a respectable 7.1% growth rate and, as Fact Set's John Butters points out in his blog, that would be over 10% if you exclude Amazon (AMZN)’s bad quarter.
The losses in the stock market, therefore, aren’t about current conditions. They are about what will or might happen over the next couple of quarters. After an extended period of loose monetary policy, the Fed has, belatedly, recognized that inflation is real and has reversed course. That means rate hikes and a reversal of QE designed to put the brakes on the economy. The forward-looking nature of the stock market demands that that be priced in now, but for markets more impacted by immediate supply and demand such as crude oil and natural gas, current conditions matter more.
Right now, strong demand for energy continues, and the Russian war in Ukraine has added to restraints on supply that have forced commodity prices to multi-year highs. That will be the case until the Fed’s policy changes begin to have a real rather than theoretical impact and we could be hitting the point where oil companies will be able to increase output without causing an immediate drop in prices. Obviously, if that is the case, energy will remain the place to be for a while.
Eventually, however, two things will come into play. Those output increases will put a cap on prices, and the rate hikes and tighter monetary policy will start to slow economic activity. If, as looks likely right now, the influence of both those things is felt at around the same time, crude, natty, and energy stocks will quickly give back a lot of their gains.
That could well be the case as early as next month, when the Fed will start to reverse its asset purchases so, from a strategy perspective, even though oil and gas can continue higher from current levels the end to the boom is in sight. That means that over the next few weeks, traders and investors should take a much more cautious approach to long positions and may even consider taking some profit on big up days. If nothing else, that will free up some capital to invest the next time everyone tells you that buying energy stocks is crazy!
