Energy Stocks: Time for a Fresh Look

After the recent sell-off in energy shares, S&P has boosted its recommendation on the sector to overweight. Here's why

by Sam Stovall From Standard & Poor's Equity Research

If someone told you that a particular sector in the S&P 500 beat the market seven out of the last eight years by an average 17.9 percentage points per year (143 percentage points cumulatively) and was still outperforming for the eighth time through mid-August of the current year, would you buy, hold, or sell?

This is the quandary confronting investors today. For those who expected the high-flying energy sector to take a breather, their wait is over. During the past 13 weeks, the S&P 1500 Energy sector fell 19%, vs. an 8.4% decline for the broader market. So is it time to exit this sector or take advantage of price weakness? We think the latter strategy is the most appropriate.

Recent Upgrade

On Aug. 13, S&P's Equity Strategy Group raised its recommended exposure to the S&P 500 Energy sector to overweight from market weight. Year to date through Aug. 15, the S&P Energy index, which represented 13.1% of the S&P 500 index on a market capitalization basis, was down 10.2%, compared with a 10.6% decline for the S&P 500. In 2007 this sector index climbed 32.4%, vs. a 3.5% advance for the 500. There are seven subindustry indexes in this sector, with Integrated Oil & Gas by far the largest at 56% of the sector's market value.

S&P Equity Research has a positive fundamental outlook for the Energy sector. We see prices for the benchmark West Texas Intermediate grade of crude oil remaining historically elevated in 2008, averaging $120.25 per barrel for the full calendar year, vs. the year-to-date average of $114 per barrel. We have positive outlooks on the Integrated Oil & Gas and Equipment & Services subindustries, which combined represent almost 75% of the sector. S&P analysts forecast that the sector's earnings per share (EPS) will rise 32% in 2008, above the flat (0%) expected growth for the broader market.

The sector's p-e on estimated 2008 earnings of 8.7 times is well below the 15.7 times p-e of the S&P 500. Its p-e-to-projected-five-year EPS growth rate (PEG) ratio of 0.6 times is lower than the broader market's 1.2 times. This sector's market-weighted S&P STARS average of 4.5 (out of 5.0) is above the S&P 500's average of 3.6.

Technical Signals

Our technical outlook for the S&P 500 Energy sector is positive. The S&P sector index has pulled back to a couple of areas of key support, and we believe that the recent correction has run its course. We think the sector has experienced a sharp contraction within the confines of a long-term bull market. While weekly momentum is still in a downtrend, the index has cycled into oversold territory, and we think this is a good spot to upgrade one of the leading sectors in the marketplace.

Relative strength vs. the S&P 500 has contracted right back to support from its 65-week exponential average and remains in a long-term uptrend. While we still think that technical indicators show that crude oil could fall further into the $100-to-$110-per-barrel range, the majority of the weakness is behind it, in our view.

In all, we recommend overweighting the S&P 500 Energy sector, as we think historically elevated oil prices, what we view as relatively low valuations, and a positive technical outlook will lead to a resumption of broader market outperformance.