- Soaring commodity prices and record oil and gas profits have made energy stocks attractive once again.
- The outperforming sector is distorting a key valuation tool used by many investors, the forward P/E ratio.
- The energy sector in the S&P 500 had gained 41.2% year to date while the S&P 500 itself is actually down 18%.
Energy stocks are outperforming the stock market—by a mile—this year. Record profits at oil and gas firms amid soaring commodity prices have made the energy sector attractive to investors. Yet, the record earnings in energy and commodity stocks are disguising a weaker S&P 500 market, where profit growth has markedly slowed down this year—it has even flattened if energy stocks are excluded.
Analysts say that energy stocks are much cheaper than other sectors based on forward-year price-to-earnings (P/E) ratios. The earnings growth of the S&P 500 in the second quarter was in the high single digits. But excluding energy, earnings were actually down year over year.
The outperforming energy sector is thus disguising the stock market's weakness and distorting a valuation tool that many investors swear by—the forward P/E ratio.
Even though the energy sector's weight in value of the S&P 500 is just 2.7 percent, energy earnings account for a tenth of the profit growth since the oil and gas stocks are the cheapest among sectors in terms of P/E ratios, James Mackintosh, senior columnist at The Wall Street Journal, notes.
Energy Sector Top Performer In S&P 500
Year to date, the energy sector has been the top-performing sector in the S&P 500 index, according to market data compiled by Yardeni Research.
The energy sector in the S&P 500 had gained 41.2% year to date to September 19. In comparison, S&P 500 is down 18.2%, and all other sectors except utilities have also lost ground since January.
Within the energy sector, the integrated oil and gas subsector has surged by 47.6%, and the oil and gas exploration & production subsector has jumped by 46.5% amid tight supply, soaring commodity prices, and expected energy shortages and rationing in Europe this winter.
Moreover, equity strategists, portfolio managers, and retail investors have grown increasingly bullish on energy stocks, the latest Bloomberg MLIV Pulse survey carried out earlier this month shows.
The poll of 814 respondents—including retail and portfolio investors, risk managers, buy-side and sell-side traders, equity strategists, and economists—showed that two-thirds of all respondents intended to increase their exposure to energy-related stocks and bonds over the next six months.
Excluding Energy, S&P 500 Earnings Are Down
However, the record profits of the energy sector are masking a much weaker overall earnings trajectory for the S&P 500.
For the second quarter, the energy sector reported the highest earnings growth of all 11 sectors at 299%, John Butters, Vice President and Senior Earnings Analyst at FactSet, said last month. The blended earnings growth rate for the S&P 500 was 6.7%, but if the energy sector is excluded, the S&P 500 would be reporting a year-over-year decline in earnings of 3.7% rather than an increase in earnings of 6.7%, according to FactSet.
For Q3, the earnings growth rate has been downgraded since June 30, and as of mid-September, the S&P 500 is expected to report annual earnings growth of 3.5%, compared to the estimated earnings growth rate of 9.8% on June 30, FactSet's Butters said in an earnings insight last week. The energy sector is the only sector that has recorded an increase in expected earnings due to upward revisions to earnings estimates. As a result, the sector's estimated yearly earnings growth rate has increased to 120.2% from 103.4% since June 30. The sector is also expected to be the largest contributor to earnings growth for the S&P 500 for the third quarter. If this sector were excluded, the index would be expected to report a decline in earnings of 2.9% rather than a growth in earnings of 3.5%, FactSet says.
The next few weeks will show whether the economic weakness will manifest itself in earnings weakness in the S&P 500 index, Liz Ann Sonders, Managing Director, Chief Investment Strategist at Charles Schwab (NYSE:SCHW), and Kevin Gordon, Senior Investment Research Manager at Charles Schwab, wrote this week.
They say:
"In a few weeks, third-quarter earnings season begins, with much hand-wringing about whether this will be the season when economic weakness translates to earnings weakness. We believe the weakness in expected earnings growth is early in its trip to an ultimate negative (year-over-year decline) destination.
Last week's FedEx news of an expected earnings implosion and the company's removal of all forward-looking guidance is a likely canary."
Last week, FedEx (NYSE:FDX) reported quarterly figures below its own expectations due to macroeconomic weakness in Asia and service challenges in Europe. Amid expectations for a continued volatile operating environment, FedEx is withdrawing its fiscal year 2023 earnings forecast from June.
A weaker macroeconomic environment could mean additional downgrades in profit estimates of many companies in the S&P 500, while the energy sector continues to reap the rewards of higher oil and gas prices compared to year-ago levels.
This makes the forward P/E ratio even more challenging to use as a valuation tool.
As Charles Schwab's investment strategists said in their research:
"Our goal in this writing is to reinforce that no one single valuation metric acts as the holy grail for determining whether the market is fairly valued."