While in the midst of a bull market in stocks that has lasted for six years, it can become increasingly difficult to find certain sectors or individual stocks that may be trading at or below perceived fair value. However due to the price of Oil, which has fell some 60% since July 2014, the Energy sector has garnered much attention recently and now qualifies as one of the best potential “value plays” for the long term investor.
I must stress that trying to pick an exact bottom on any market is futile. I am sure investors have been trying, to no avail, since the price of Oil hit $75 a barrel. However I believe that studying the price patterns can give us some good guidelines to find reasonable areas to do business.
In the price chart above I am using the S+P 500 Energy Sector Index ETF, this fund owns the entire basket of energy stocks in the market benchmark and so it gives a good barometer of the relative weakness.
The energy sector has experienced four separate corrections since the market bottom of 2009. I have highlighted each one for reference. Three out of the four corrections were of the $14-$15 or 20%-24% variety while the biggest correction came in 2011 and that equated to a $26.75 drop or about 33%.
We now find ourselves in a position where the Energy sector has matched the size (by $ amount) of the 2011 correction. I have highlighted this price level ($74.78) as it’s the upper most green horizontal line. For now price has stabilized around this level however in the event of further weakness the next major area of support, as I see it, comes in around the $68 – $69.50 area. The $68 price level would match the size of the 2011 correction in terms of percentages (33%) and so I have highlighted it as the bottom green horizontal line. While the $69.50 level happens to be the midpoint of the entire bull market run over the last 5 years and it is represented as the red horizontal line on the chart.
The chart above is Morningstar’s view on the markets valuation. A valuation number above 1.00 is considered Overvalued and a number below 1.00 is considered Undervalued. While this in itself is far from a market timing tool, it is helpful to analyze the fundamentals as well as the technicals in assisting in the decision making process. According to Morningstar the overall market is slightly overvalued at a reading of 1.03.
Contrast that with their take on the Energy sector, which has a reading of 0.89 or undervalued. Indeed this reading is the lowest it’s been since 2011 and only exceeded by the 2008 financial crisis. Now we must understand a “cheap” stock can always continue to get “cheaper”, which is why asset allocation and diversification is a critical component to your long term plan. I must again stress that I have no idea about when and where the exact bottom in Energy prices will occur. However for longer term investors looking for value in a seemingly fairly valued to overly valued market condition, these price levels appear to offer good prospects for the future. (Disclaimer: Long XLE)