Research.LeutholdGroup

Fundamentally, we don’t have much new to say on the disaster that Energy-sector equities have become. Mostly, we want to illustrate the danger of assuming that the stocks of commodity producers will necessarily follow the path of their underlying commodities.

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With crude trading at only about half the level seen in the first few years of this expansion, there might be a tendency to view its current price as depressed. But from an inflation-adjusted perspective, today’s price sits right on top of its modern-era (post-embargo) median.

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The “robustness” of the “Cheapest Sector Strategy” concept is illustrated by strong results across all rebalancing frequencies.

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Someone forgot to tell commodity trades this is an era of diversity of inclusivity: This year’s leap in the S&P/Goldman Sachs Commodity Index has been entirely the result of its heavily-weighted energy inputs.

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Crude oil and the U.S. Dollar Index accomplished a relatively rare feat by moving to simultaneous six-month highs earlier this week (Chart 1).

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While watching a forecast go awry is painful, there’s an alternative that we consider to be even worse: the failure to be paid on an accurate forecast. The resulting feeling of helplessness must be similar to that of a corporate director who manages to lose money on inside information.

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Anticipating prolonged weakness of energy prices, we advise avoiding two segments within the Energy sector: companies with high balance-sheet risk, and special Energy investment vehicles called Energy Royalty Trusts.

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We revisit commentary we published in 2015 regarding the late-2014 oil price crash and review why, at that time, we believed oil prices could stay at depressed levels for a longer period than most expected. Additionally, we advise avoiding two Energy sector segments: companies with high balance-sheet risk, and Energy Royalty Trusts.

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We wrote a year ago that the Energy sector’s 2014-2016 decline of 47.3% was the worst-ever sector decline occurring outside of a cyclical bear market.

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The gap between crude oil prices and Energy sector RS is now much wider than seen even at that historic 2014 juncture. The “divergent” weakness in Energy stocks suggests that crude will likely trade lower.

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Remember the special amplifiers used by the fictional rock group Spinal Tap that could be dialed up to eleven? S&P’s decision last year to designate Real Estate as a full-fledged sector means that our GS rankings can now be dialed down to eleven, and unfortunately the Energy sector has been a frequent occupant of that undesirable spot.

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The latest Green Book highlighted the unusual divergence between crude oil and the relative performance of the S&P 500 Energy sector. Crude prices had—until this week—been trading near 18-month highs, while the relative strength of Energy stocks had slipped back towards January 2016 lows.

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One of our disappointments with the Group Selection (GS) Scores in 2016 was their failure to latch on to the rebound in Energy groups.

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Despite putting in lows in January, the Energy sector has been stuck at the bottom of the GS rankings, and the sector has given up more than half its relative gain over the last several weeks. Perhaps the GS Scores will highlight a better entry point in the months ahead.

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Despite recent bounce among stocks in the Energy sector, the GS Scores still rate Energy groups poorly.

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The Leuthold Materials sector jumped five spots to #3 in the June Group Selection (GS) rankings, its highest ranking in eight years and the first reading outside of the bottom four in almost four years.

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Last month we wrote that a big March gain would trigger a Very Long Term (VLT) Momentum BUY signal on the S&P 500 (Chart). The month’s 6.8% S&P 500 gain wasn’t quite enough to do the trick, but we’re intrigued that VLT did issue BUY signals for three of the market’s cyclical sectors, including Energy, Materials, and Industrials.

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The market’s latest infatuation with bonds was driven by grave concerns that the weakness in energy and manufacturing sectors might be spreading to the U.S. economy as a whole.

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New developments have lifted sentiment toward oil and Energy names, but we caution bottom-fishers to be mindful of risks. The fundamentals in the oil patch do not yet support strong oil prices going forward.

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In view of the last year’s steep decline in oil prices, Energy has been a frequent headline topic.

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The S&P 500 Energy sector’s latest plunge puts it down by almost a third in the last 14 months. It now belongs to an exclusive list of sectors which have declined 30% on both an absolute basis and relative to the S&P 500!

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It’s more complicated than one would think. Besides input costs, one must consider the impact on revenues, and whether various pricing differentials come into play.

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Has the recent collapse in crude oil prices presented us with a good opportunity for an outright commodity investment? No. Energy stocks aren’t on our radar screen either.

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We’ve been highlighting the overinvestment (or malinvestment) risks in commodity-oriented equity sectors for the past three years, but we certainly did not foresee those risks exploding the way they have in the oil market over the last seven months.

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A big question for investors is: have oil prices bottomed? For the past four days, WTI jumped 19% from its low reached on January 28th, giving some the conviction that prices are reverting back to prior high levels.

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The recent Energy sector decline has accomplished the feat of wiping out all of the upside gains achieved during its “Third Act” played out in the 2006-2008 surge.

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In the August book we published an article about the Indian equity market and proposed that investing in India is now more of a macro bet. The honeymoon—during which time Indian stocks were bid up from high hopes that the new government would reinvigorate the economy—is over.

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Strength in the Energy sector has been so compelling that our two recent Energy group allocations together now make up a 10% portfolio weight, after having no Energy exposure from June 2013—April.

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We’ve been negative on commodities and most commodity-oriented equities for the last three years, believing that the magnitude of the ramp-up in commodity production capacity over the last decade remains generally underappreciated by investors.

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The year’s second biggest surprise (next to the relentless drop in bond yields) might be the YTD bounce in the major commodity indexes.

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The only Energy group rated Attractive, its score has improved for seven consecutive months.

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All ten of the S&P 500 sectors recorded a sequential increase in four-quarter trailing net profit margins. But consider where sector margins stand today relative to their 25-year medians. Eight of ten S&P 500 sectors are recording profit margins well above their long-term medians.

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While gold garnered most of the headlines last year (down 27%), commodities performed badly across the board in 2013. We expect more of the same in 2014.

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We find hidden opportunities in Equipment & Services Providers, Coal and Natural Gas. We consider these themes longer term holdings instead of short-term plays

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Both models have numerous Information Technology and Financials groups in Attractive territory. Neither model has any Unattractive Tech groups. Alternatively, neither model has any Attractive Utilities groups, while several Utilities rate Unattractive in each.

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Both models (particularly domestic) have a number of Attractive rated Information Technology groups and no Unattractive rated Tech groups. Financials’ domination of the Global Attractive range continues.

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We’ve noted before that profit margin gains since the technology boom have been primarily a Large Cap phenomenon.

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We examine Emerging Markets from both the top-down and bottom-up perspectives as we try to identify where to move and what to expect. We check in on two successful EM thematic group ideas as well.

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For more than two years we’ve discussed the supply-side risks to commodity producers stemming from capacity built during the manic “Third Act” of last decade’s Three Act Play in commodities. Commodity-oriented equities have indeed underperformed since 2011, but to date, most pundits have laid blame squarely on the demand side.

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