(08/28/13) Compelling Case for Energy

The energy sector has captured only 75% of the return in the S&P 500 over the last two years. In spite of this recent underperformance, there are several compelling reasons to maintain, at least, a market weighting in energy right now, says James Stack, editor of InvesTech Market Analyst.

With more than four years of bull market behind us, and divergences, or potential warning flags starting to appear, it's important to focus on defensive late-stage sectors.

The energy sector is typically a late-stage bull market leader and has historically held up well in bear markets.

Data from Ned Davis Research looks at the S&P 500 sectors ranked on their average performance in the final third of bull markets over the last 40 years. Energy is a late-stage sector that beat the S&P 500 Index. Since 1974, energy has outperformed the S&P 500 in two-thirds of late-stage bull markets.

The energy sector also provides a valuable inflation and US dollar hedge, and with the burdensome level of US debt, the dollar remains vulnerable.

When looking at the most resilient sectors to hold, during periods with rising interest rates and inflation, energy has historically been one of the top choices.

It significantly outperformed the S&P 500 in about half the inflationary periods since 1972, and only significantly lagged the index once, in 1980-82. Although inflation is not yet a problem, we're already seeing an upturn in long-term interest rates.

Energy prices also tend to move opposite the value of the dollar. Most crude oil transactions are conducted in US dollars, which creates a unique inverse relationship between the value of the trade-weighted dollar and oil prices.

Today, risk to the dollar is a primary concern for investors, as high US debt levels continue to increase. Thus, holding a market weighting in energy can provide some much needed portfolio insurance.

Another study, by Ned Davis Research, of recessionary bear markets, found that energy was the most resilient sector during the period, from the stock market peak, to the start of recession.

The sector outperformed the S&P 500 in all six cases since 1973, with energy stocks often continuing to climb in the early months of a bear market.

From the peak in major stock market indexes, to the start of recession (on average a little less than eight months), energy has averaged a gain of 10.5%. With strong early bear market leadership, this has historically turned out to be one of the best sectors to hold in a downturn.

Lastly, energy holdings are also a hedge against escalating trouble in the Middle East.

While the US is gradually becoming less dependent on imports—due to new drilling techniques and domestic production gains—the risk of a disruption to global oil supply and transport still has a powerful impact on energy prices. So, maintaining a market weight allocation in the energy sector is prudent.

In timing energy trades, seasonal energy sector performance indicates that the upcoming winter months are a good time to hold oil and gas stocks. The reason is that demand for energy increases in proportion to the cold weather.

To study seasonal strength, we averaged the monthly returns for the S&P 500 Energy sector over the past 23 years. December through May (with the exception of January) typically produces the best gains.

As heating requirements ease, summer through fall is a lower demand period. July, however, is a bright spot, as summer driving contributes to a jump in utilization. Bottom line, early fall is a better time to buy, rather than sell, energy stocks.