Seven Reasons to Like the Energy Sector

Additional content provided by Colby Hesson, Analyst, Research.

Energy has had a strong 2024. Through April 8, the S&P 500 Energy Sector Index has returned 16.3% year to date, trailing only communication services, which has gained 18.9% (compared to the S&P 500 return of 8.8%). LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) continues to recommend overweighting the sector, which currently makes up just 4.1% of the index. The STAAC has identified a bunch of reasons to still like the sector, which we have narrowed down to seven here.

1 — Technical strength. The sector recently rallied to record highs after surpassing key resistance off the 2022–2023 highs. The breakout was confirmed by bullish momentum and broad-based buying pressure. Over 90% of sector stocks are now trading above their 200-day moving average, while nearly half of the sector registered new 52-week highs earlier this month. Based on the size of the prior consolidation range, a minimum technical-based price objective points to around 20% of further upside from current levels.

Energy Has Its Foot on the Gas

Source: LPL Research, Bloomberg, 04/08/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

2 — Favorable seasonality. April is the best seasonal month for the energy sector, based on 40 years of data. As seasons change and the U.S. economy transitions away from the winter heating season and toward the summer driving season, we typically observe increases in energy consumption. Industrial agriculture activity picks up, as does vacation travel. The energy sector, based on Ned Davis Research data, achieved an average return of 3.6% in April.

April Historically Best Month for Energy Sector Performance

Source: LPL Research, Ned Davis Research 04/08/24
Disclosures: Ned Davis Research created a proprietary proxy version of the S&P 500 Energy Sector Index going back to 1980. All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

3 — Developing rotation away from mega cap technology. The Magnificent 7 was the story of 2023, but we are noticing some hiccups in some of those big names in early 2024. This market seems to be searching for something to buy besides the big technology winners, and cyclical value would be a logical place to go. During March and early April, the Russell 1000 Value Index outpaced its Growth counterpart by about 260 basis points (2.6 percentage points), during which five of the top six sectors were value-oriented (energy, financials, industrials, materials, and utilities), while shares of Apple (AAPL) and Tesla (TSLA) have fallen.

Shifting to cheaper areas makes sense given how far growth stocks have run (note that LPL Research lowered its recommended large cap growth allocation last month but remains slightly overweight). In a potential pullback, the sector pricing in the most optimism could be under the most pressure. For those exploring somewhere to go with mega cap technology proceeds, we would consider industrials as one idea because of improved recent performance, energy and infrastructure investment, and the near-shoring theme.

4 — Attractive valuations. Producers’ increased focus on cash flows provides valuation support for the energy sector. As profits improve and allow for more dividends, share buybacks, and debt reduction, we would expect sector valuations to re-rate higher. Consensus estimates for profit and cash flow growth through 2025 are in the high-single digits.

Energy Sector Cash Flow Valuations Remain Attractive Despite Recent Gains

Source: LPL Research, FactSet 04/08/24
Disclosures: A higher free cash flow yield (free cash flow dividend per share divided by price) indicates a cheaper valuation, and vice versa. All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

5 — Strong earnings revisions. Earnings revisions for energy are the best among all S&P 500 sectors over the past month, which we find especially relevant with the first quarter earnings season right around the corner. Favorable revisions, in concert with higher oil prices, have the sector poised for solid upside to estimates, in our opinion. Better capital allocation decisions by producers should help increase the chances that the sector’s earnings are well received by markets, although a strong U.S. dollar may present a bit of a short-term challenge.

Energy Has Seen the Strongest Earnings Estimate Revisions Over the Past Month

Source: LPL Research, FactSet 04/08/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. Estimates may not materialize as predicted. 

6 — Potential protection against sticky inflation and rising rates. Inflation near 3% based on the Personal Consumption Expenditures (PCE) deflator remains above the Federal Reserve’s (Fed) 2% target even after the significant improvement from the 40-year highs of 2022. That last mile of inflation has proven stickier than some had anticipated and hoped, while we know from history that sometimes inflation comes in multiple waves. All that suggests investments that tend to perform better when inflation rises, as energy tends to, could make sense. Energy is also the only sector positively correlated to 10-year Treasury yields, providing investors with a potential portfolio hedge against higher rates.

7 — Upside potential to oil prices. The tenuous situation in the Mideast offers potential upside to oil prices should Iran be drawn further into the war in Israel. Meanwhile, global supply is being curbed by OPEC+ production caps and the Russia-Ukraine conflict, including Ukrainian drone strikes on Russian oil production facilities. And on the demand side, the outlook has firmed recently in Europe and China based on the latest manufacturing surveys, while the U.S. economy continues to chug right along despite headwinds, all of which could support potential further gains in oil prices, which are already up about 20% this year.

There you have it. Seven reasons to like the energy sector — a recommended tactical overweight for LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC). Key risks to consider are: 1) lower oil prices if the geopolitical risk premium erodes; and 3) a potential second-half slowdown in the U.S. economy.

If you’re interested in exploring investments with an energy focus available at LPL Financial, please contact your advisor.