We’re not certain that the historic rout in the Energy sector is over, and even if we were our Group Selection (GS) Scores would likely prohibit us from loading up on Energy subgroups for at least a few more months. Pure valuation work has certainly proven misleading, with our Energy “relative valuation composite” (Chart 1) suggesting the sector stood on the brink of extreme undervaluation even before it became unglued in the sector half of the year. For what it’s worth, today Energy’s relative valuation level (a composite of Normalized P/E, Price/Cash Flow and Price-to-Book ratios) is the lowest in our 25-year history for this sector.
Last decade we frequently discussed the “Three Act Play” then unfolding in commodities, with the terminal act producing a 2006-2008 surge in commodity-oriented equities and a commensurate binge in capital spending. While all of the commodity sector participated, Energy certainly played either a lead or a co-starring role (Chart 2).
But we’ve seen the “Third Act” of similar plays before. They are inevitably self-correcting, with excessive speculation and overinvestment sowing the seeds for the next decline. Other analysts might call the Third Act the “distribution” or “public participation” phase, while students of Elliott Wave theory would call it a terminal “fifth wave.” At any rate, the general rule of thumb is that all of the upside move occurring during a Third Act is wiped out during the ensuing bear market. The Energy sector decline of 2008-2009 didn’t quite accomplish that feat, but the latest sell-off has—perhaps a positive sign.
Energy’s peak-to-trough decline of –26.7% (to-date) is the second bear-market decline of magnitude suffered by the sector during the current cyclical bull market (Chart 3). The first was a –28.4% drop in mid-2011. Next, we compare these moves to other significant sector declines occurring outside of a broader bear market.
How common are “self-contained” sector bear markets like the one just experienced in Energy? We scanned S&P for sector declines of 20% or more which occurred outside of S&P 500 cyclical bear markets. There were only 19 other instances since 1990.
· Financials (four instances) was the most vulnerable sector to big declines independent of cyclical bear markets. Consumer Discretionary is the lone sector that did not suffer a stand-alone decline of 20%.
· The encouraging news is that once a “rogue” decline in the respective sector has ended, relative performance (on average) over the next three, six, and 12 months has been good. The sector in question outperformed the S&P 500 by an average of 15% in the year following its “stand-alone bear market” low (… albeit with a few notable failures).
© 2015 The Leuthold Group