CVX Chevron Corporation

By Tim Mullaney 

It's one of Wall Street's best-known maxims: The "Dogs of the Dow" principle, holding that Dow Jones Industrial Average companies whose stocks underperform the broad market in a given year but are basically healthy typically will bounce back and maybe even outperform the market the next year. And it generally holds true.

But does a similar rule apply to sectors of the S&P 500, and sector-based mutual funds and exchange-traded funds? Inquiring energy investors, in particular, may want to know.

The answer is, kind of, says Sam Stovall, chief investment strategist at CFRA Research. Because any one of the 11 sectors represented in the S&P 500 is a bigger boat to turn around than one company, it takes longer. But market history suggests that sectors that underperform in one decade do tend to outperform in the next: It happened for tech shares in the 2010s after a decade marked by two collapses in tech stocks, and it happened for utilities in the early 2000s after they sat out the 1990s boom led by tech stocks.

"Typically the best-performing sectors in one decade become the worst in the following decade, and vice versa," Mr. Stovall says. "Since energy was the best in the 2000s but the worst this [past] decade, maybe the 2020s will be its day in the sun."

But energy, and funds that follow it, are trapped in a set of conundrums that make the sector's potential for a rebound a tricky question. On the positive side, energy shares have gotten cheaper: The S&P 500 Energy subindex trades at only about 0.4 times book value, half of 2008's level and a third below 2016, according to Bank of America Merrill Lynch. That argues for a rebound. However, financial stocks are significantly cheaper on the basis of price-to-earnings ratio, so they may be more attractive to value investors.

And the energy industry is still plagued by the prospect of oil-and-gas overcapacity in the short term, and over time a series of technical innovations -- including electric vehicles and wind-powered electricity -- that threaten to make traditional energy players smaller and less relevant.

How fast the technology moves, and becomes cheaper than existing ways of doing business, will determine whether technological changes threatening to push energy stocks lower overwhelm cheap valuations that would tend to drive shares higher, CFRA energy analyst Stewart Glickman says.

Many challenges

One scenario is that there may be a window between the time when big energy companies fix their existing problems like oversupply of natural gas, allowing for returns to rise, and the time when long-term issues like the rise of electric vehicles threaten demand growth for petroleum and pressure energy-related shares anew. Any investors hoping for a rebound could be rewarded in that window.

"You might get a five-year sweet spot," Mr. Glickman says.

From the start of 2017 to the end of last year, investors pulled $12.4 billion from energy-focused mutual funds and ETFs, Morningstar analyst Amrutha Alladi says. Combined with capital losses from falling stock prices, that pushed the amount in energy funds to $30.2 billion at year-end 2019 from $55.9 billion three years earlier.

The sector has gotten off to a shaky start in 2020, falling 9.8% compared with a 3.6% gain for the broader market, after a 1% gain in 2019 trailed the market by 25 percentage points. Merrill strategist Savita Subramanian rated energy shares "equal weight" in a recent report, meaning investors should hold about as much of their money in energy shares as the industry's share of the total stock market, currently around 4%.

"The sector represents deep value," Ms. Subramanian says. Still, "traditional commodities are shunned by an increasing number of [socially conscious] investors," she says. "The secular replacement story is also a headwind," she says, referring to the idea that people will use less gasoline as they switch to electric cars and less natural gas as renewable energy takes a larger share of the electricity market.

In the short term, oil-and-gas shares also are pressured by activist shareholders' demands that energy companies cut capital spending, already down 35% since 2014, in the wake of criticism that the hydraulic fracking boom led to overinvestment and too much oil supply.

There's disagreement about how soon or how deeply lower capital expenditures will cut into growth of U.S. oil production. But if production growth does drop, boosting prices, that would give energy companies room to increase profits -- and to use their improved cash flow for more stock buybacks or dividends, Mr. Glickman says. Chevron and Exxon Mobil boosted dividends by 6% last year, and ConocoPhillips in November launched a share buyback that could purchase shares worth half of the company's current market value over 10 years.

Future risks

By an optimistic reading, this points to a possible window of opportunity for share-price gains around 2021 or 2022, Mr. Glickman says. But then, energy investors have to look out for the risks coming later in the decade.

The biggest of those risks is the growth of electric-vehicle sales, and the key thing to watch on that front is how soon declining battery prices make EVs cheaper than gasoline-powered cars and trucks, even without the tax subsidies that have helped speed the adoption of electric vehicles so far. That could happen by 2022 to 2024, according to analysts at Bloomberg New Energy Finance, citing an 87% drop in battery costs in the past decade.

In this scenario, gasoline demand plummets. But there would still be winners in the energy sector, says Robert Thummel, a portfolio manager at energy-focused fund group Tortoise Capital -- companies involved in producing electricity to power the new cars. "Electricity demand will be the driver in the next decade," he says.

That could lead energy investors and funds in new directions, he says -- especially big bets on utilities and energy infrastructure like electric grids.

A decade is a long time, of course, and even newer innovations than fracking, EVs and widespread wind power could disrupt energy markets by 2030 -- it has happened before.

Mr. Mullaney is a writer in Maplewood, N.J. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

February 09, 2020 22:23 ET (03:23 GMT)

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