Buy Energy Stocks During Downturn

The global stock market selloff continues unabated with most major market indexes touching five-year lows. The S&P 500 is close to retracing the entire 2002-07 bull market. The speed and strength of this selloff certainly qualifies it as among the most vicious in stock market history.

Clearly, energy stocks haven’t been immune to the selling. The Philadelphia Oil Services Index (OSX) is now trading at levels unseen since 2005. That index has halved in value since the end of August, underperforming the S&P 500 since that time.

Over the past month and a half, many investors have asked: What’s the fundamental rationale for the selling in the energy sector? The simple truth: There’s no fundamental rationale for the moves we’re seeing in energy stocks.

Long-time subscribers know that I’ve always made a point to differentiate groups within the energy patch in my premium service, The Energy Strategist. It’s always been my view that investors can outperform the broader energy indexes by carefully selecting individual stocks and energy subsectors.

The biggest mistake investors make is to assume that you can simply buy ExxonMobil and declare that you’re exposed to energy. Exxon is a fine company, but it isn’t a proxy for the energy sector.

These stocks don’t all move as a group. Take the Philadelphia Oil Services Index as an example. This index includes just 15 stocks all supposedly in the services business; however, in 2007 the top three performers handed investors gains of close to 100 percent compared to a negative return for the bottom three. My point: Even within a relatively homogenous group, there are often wide variations in performance.

There is only one time when this isn’t the case. During bear markets of the sort we’re experiencing today, all stocks become correlated. All energy stocks are getting painted with the same brush regardless of their individual fundamentals.

There’s a case to be made that a global economic slowdown will have an effect on crude oil demand. In fact, a close to 1-million-barrel-per-day drop off in US oil demand this year has certainly offset continued growth in developing world demand. But that isn’t a realistic explanation for the collapse in oil prices and related stocks since the end of August.

As I noted in the last issue of The Energy Letter, oil supplies continue to look tight. Further, the International Energy Agency (IEA) and Energy Information Administration (EIA) are now suggesting that non-OPEC (Organization of the Petroleum Exporting Countries) oil production will actually shrink this year compared to earlier estimates for a 1-million-barrel-per-day increase. The word is hardly awash in oil.

Natural gas and related stocks are being hit by the idea that a wall of new supply for unconventional US reserves will swamp demand and lead to a major glut of gas. That said, natural gas inventories remain less than 70 billion cubic feet (bcf) above normal for this time of year, and several shale producer have responded to lower gas prices by cutting back their production plans, further tightening supply.

The main reason energy stocks are getting hit is that investors are in panic mode. They’re liquidating all of their positions to raise cash. The credit system remains frozen solid, making it tough for the market to function properly.

The good news: Markets of this nature produce myriad opportunities. As I pointed out in the last issue of TEL, many of my favorite energy firms are now trading at valuations unseen in a decade–when oil traded closer to $10 per barrel in comparison to the current $80-per-barrel level. It won’t take much of a positive catalyst to send these depressed stocks sharply higher.

The big question is how to play it. My recommendations remain unchanged: Consider putting some cash into high-quality, beaten-down names; I offered a list of my top plays right now in the last two issues of TES. These stocks are still down, and I can’t tell you that they won’t fall further near term. However, I’m confident that, over a longer timeframe, these are stocks you want to own.

But don’t try to time the bottom of the market; be sure to keep some powder dry. I suspect we’ll see the carnage end over the next week or two, and some sort of rally will kick off. Given how depressed and stressed to the downside they are, some of my favorite energy plays could easily see gains of 100 percent or more by yearend. I suspect a rally is coming, and it will be well worth catching.

The obvious question is how to spot the end of this carnage and a stabilization of the market. I’m watching two indicators.

First, the S&P Volatility Index (VIX), a measure of how much volatility is priced into the S&P options market. Suffice it to say that when the VIX is elevated, S&P options traders expect large moves to occur in the underlying index. A high reading on the VIX indicates significant market uncertainty.

The VIX often spikes because traders are buying put insurance en masse. To make a long story short, traders are buying puts on the S&P at high prices to insure their portfolios against major loss. A high VIX reading means elevated levels of fear in the broader market.

The VIX is a contrary indicator, meaning that high readings tend to correspond with lows in the major market averages. Check out the chart of the VIX below for a closer look.

You can clearly see the big spike in the VIX to the low 40s in the wake of the terrorist attacks Sept. 11, 2001. In that cycle, the VIX actually topped out Sept. 20, 2001. The US economy was very weak at the time, and the bear market in stocks still had more than another year to run; however, that VIX spike signaled the start of an impressive fourth quarter rally in the S&P 500 that carried the index up 17 percent by yearend.

The next spikes occurred in the summer and autumn of 2002, followed by another mini-spike in early 2003. Of course, these moves in the VIX signaled the bottom of the 2000-02 bear market. The S&P 500 ultimately enjoyed a near five-year rally off those lows.

The recent spike looks similar. You can clearly see on the chart that the VIX actually reached highs that are well above the immediate aftermath of the Sept. 11 attacks.

This spike in the VIX is indicative of a bottom in the stock market. There’s no way to know how high the VIX must go before the market bottoms; look for a reversal in the VIX. If history is any guide, the VIX should begin to plummet to more normal levels in the mid-20s as the rally takes hold this quarter. Such a move would indicate a return of willingness to take on risk.

The second indicator to watch is the so-called TED spread—a measure of the difference between the three-month London Interbank Offered Rate (LIBOR) and the three-month Treasury bills. Check out the chart below.

As you can see, the TED spread is highly elevated. What this means is that the LIBOR (interbank) rate is elevated relative to Treasuries. In other words, banks are reluctant to lend to one another.

A decline in the TED spread to more normal levels would indicate a return of confidence into the credit markets. I’ll be keeping tabs on the market and these indicators over on KCI Investing’s blog, At These Levels (www.attheselevels.com). Feel free to post comments to the blog and check out our new format.

Speaking Engagements

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Roger Conrad for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011361 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with me and my colleagues Roger Conrad, Gregg Early and Neil George.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

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