Russ discusses why energy, despite rallying – and outperforming -- this year, still looks like a value.
The S&P 500 Index rose roughly 8% in January, the best start to a year since 1987. Despite the magnitude of the rally, the S&P 500 Energy Sector has outperformed by more than 5%. As impressive as the gains have been, January’s rally still leaves the sector below where it started December.
When I last highlighted energy stocks in mid-November I focused on the discrepancy between the sector’s valuation and oil prices. Shortly after both the sector and the commodity promptly plunged: Between mid-November and the Christmas Eve low the S&P 500 Energy Sector Index dropped more than 20%, having already lost about 14% from the October high. As a result, despite the magnitude of the recent gains the sector remains cheap. Consider the following:
- The energy sector closed January at 1.7 times price-to-book (P/B) value. While this is roughly 10% above December’s multi-decade low, current valuations are still below the depressed levels witnessed in November and in the bottom 10% of historical observations.
- On a relative basis U.S. energy companies continue to trade at the largest discount to the broader market since at least 1995. The P/B on the sector is about 50% of the broader market’s (see Chart 1).
- As discussed last November, energy is not only cheap versus the broader market but also relative to the price of oil. Historically, the price of oil has explained roughly 20% of the variation in the relative multiple of the sector. At $54/barrel, crude oil prices suggest the sector should be trading at an 18-20% discount to the market, not a nearly 50% discount.
The dollar matters
One potential explanation for the magnitude of the recent discount: the dollar. A stronger dollar has historically been associated with lower relative valuations. Since 1995, the relative P/B of the energy sector has been approximately 10% higher when the Dollar Index (DXY) is lower year-over-year versus times when the dollar is higher. This relationship is arguably a function of several factors. A weaker dollar is supportive of commodity prices, which are generally denominated in dollars, as well as representing a de facto monetary easing.