Co-Head of Global Equity Strategy
Co-Head of Real Asset Strategy

Analysis and outlook for the equity market

  • Oil prices have declined by more than 75 percent from their 2014 highs.
  • Yet we recommend that investors resist the urge to raise energy-stock exposure now, given the historical delay in energy stocks bottoming following an oil-price bottom.

What it may mean for investors

  • Once a bottom in oil prices is found, we recommend that investors reassess their energy-share commitment. We hold an even weighting (neutral) on the Energy sector, but see potential today in sectors such as Consumer Discretionary, Technology and Industrials that may benefit from lower oil prices. 

Resist the Urge to Increase Energy-Stock Exposure

The impact of lower oil prices on equity markets has dominated our conversations with investors over the past few weeks. The questions center on why the declines in oil prices have become so positively correlated with negative equity prices and whether it is time to buy energy stocks. In this Global Equity Strategy Report, we consider the latter question: when investors should consider increasing exposure to energy stocks. 

The 75.4 percent oil-price decline (since the 2014 peak) is now the second steepest drop since the early 1980s. As oil fell below $30 per barrel last week, market participants asked: has oil bottomed? While it is tough to call the bottom, we do believe that it is close. Equity investors may want to watch energy-sector shares as energy stock action can, and often does, help to predict oil-price lows. Energy stocks have continued to decline during the first few weeks of 2016. If we should see them begin to move sideways in a trading range, it may signal an end to lower oil prices.

The next question investors may then have is whether they should consider buying energy stocks once an oil-price low is found. Our work has shown that the answer often is, surprisingly, “no.” Finding a bottom in oil prices does not mean that energy stocks have to stop declining in price. Energy-stock performance tends to underwhelm after oil bottoms are found.   

A Closer Look

It may seem confusing that an oil-price bottom may offer a tactical oil-commodity buying opportunity but not a buying opportunity for energy stocks. Essentially, energy stocks hitting new lows can be a sign of the energy equity sector beginning to bottom, but not necessarily a timely sign. Chart 1 provides some useful insights. In this chart, there are three key lines: the price of oil (blue line), the average energy sector performance (green line), and the energy sector vs. the S&P 500 Index (purple line). The vertical black dashed line represents the bottoms of the seven most severe oil-price drops (1986, 1988, 1991, 1994, 1998, 2001, and 2008). It is worth noting that the energy sector absolute performance (green line) starts flattening a few months prior to the ultimate bottom. 

A historically better indication to an oil bottom than the average energy stock bottoming tends to be the relative strength of energy stocks vs. the S&P 500 Index (purple line). This ratio tends to stop falling once a low in oil prices is found. However, the bottom in relative strength is not a leading indicator. The relative strength low occurs, on average, about the same time that oil bottoms. So to be clear; relative strength can help confirm that an oil bottom is in place after the fact. Yet it will not necessarily help an investor to make an early oil-bottom call. 

Chart 1. Oil and Energy-Sector Performance around Steepest Oil Declines Since 1985

Oil and energy sector performance around steepest oil declines Since 1985. Contact your Relationship Manager for more information.

Sources: Ned Davis Research, Wells Fargo Investment Institute, 12/15/15. Notes: Data indexed to 100 representative of the black dashed line. The energy sector absolute performance represents the average stock performance in the S&P 500 Energy Index. Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved.

As Chart 1 shows, seeking to capitalize on a near-term bounce in energy stocks is not an easy strategy to exploit. A bounce historically did not last long, so investing for an energy bounce may depend on an investor’s time horizon. If an investor has a long-term horizon, seeking to capitalize on a bounce in energy-stock prices is likely not worth the risk. The key point is that it will likely take some time for energy stocks to recover. Energy stocks historically have bottomed, on average, two months after the ultimate oil-price bottom. 

Investment Implications

We will be monitoring markets for a bottom in oil and would then recommend that investors reassess their commitment to energy shares.  Buying energy stocks early, in the hopes of timing an ultimate oil-price low, currently does not appear to be worth the risk.

Yet one strategy we favor to potentially capitalize on lower energy costs is to look at sectors that are the beneficiaries of lower oil prices. These sectors include Consumer Discretionary and Technology. Additionally, the beaten up Industrials sector could start to see some benefits from the impact of lower energy costs on operations.  Earnings announcements in the coming week will likely give us additional insight into the lower cost of energy on margins for many companies. The initial hit to domestic earnings has clearly come in the form of the large energy-earnings decline (due to the dramatic drop in crude-oil prices). Yet the positive benefits to the consumer and to business entities generally takes longer to become evident as the declines in costs work their way through a broader segment of industries. We would expect that some companies have not yet seen the margin benefit to lower costs, in part due to their contract cycle for purchasing commodities and other inputs whose prices have declined. We continue to recommend that investors consider our overweight recommendation for Consumer Discretionary, Technology, and Industrials, and our evenweight (or neutral) stance for the Energy sector.

Weekly Wrap and Look Ahead

All major equity indices were positive for the week, but all were negative year to date.

Market index performance for the week of January 18-22, 2016 and 2015 year-to-date. Contact your Relationship Manager for more information.

Six of 10 S&P 500 Index sectors outperformed the index and eight of 10 managed to gain ground for the week.

Best and worst performing sectors for the week of January 18-22. Contact your Relationship Manager for more information.

The big question this week involves the Federal Reserve (Fed). Will the Fed raise rates in the near term, for example at the March monetary policy meeting? We believe that there is a low probability of the Fed announcing another rate hike at this week’s meeting on Tuesday and Wednesday. Investors will, however, be looking for clues as to when the next rise in the fed funds target rate will occur.  We would not expect much clarity on this subject at this particular meeting. There are a lot of moving parts in financial markets and economies right now. We also suspect that the Fed will want to strongly hint when the next rate hike will occur well before it actually happens (i.e., two or three months ahead of time).

In the meantime, the price of crude oil will continue to influence day-to-day trading in the equity market. For better or worse, stocks are tied to the ups and downs of this volatile commodity. We expect oil to find a bottom within the next six months, but investors can expect quite a bit of volatility over that time frame and beyond. The full benefits of lower energy prices have yet to work their way through the rest of the economy, but as hedges roll off, we look for the benefits to broaden to many segments of the economy.

There are quite a few economic reports on the schedule this week, and we are in the thick of the fourth-quarter earnings reporting season. This week, investors will get the first government “guesstimate” of fourth-quarter gross domestic product (GDP). The consensus is calling for just 0.8 percent quarter-over-quarter annualized growth after a two-percent growth rate was posted in the third quarter.

Our work continues to suggest that the American economy should not slip into a recession in 2016. We look for modest growth with only modest inflation. Our call is for the Fed to hike interest rate twice this year, most likely in the second half of the year. We view the current correction as an opportunity in the equity market.

Sector S&P weighting as of close January 25, 2016. Contact your Relationship Manager for more information.

Source: Wells Fargo Investment Institute, Bloomberg, 1/25/16