OCEAN CITY — After the financial market fireworks of last year, first-quarter returns across many assets have been within a narrow range. Markets are generally flat to slightly higher, with stock returns muted despite recent data showing signs of improvement in the U.S. economy.
Many measures of volatility and political uncertainty remain at low levels. We believe this restraint in markets is due in part to higher starting valuations coming into 2014 and to investor concerns over how long the U.S. Federal Reserve will continue to underwrite low interest rates. The low rates make all sorts of riskier investments, like stocks, more attractive.
In markets dominated by the actions of central banks and by most broad measures not unambiguously cheap, investors need to search harder to find value and income. Fertile ground
for their exploration includes the energy sector, in our view. It provides answers to two timeless investment questions that should guide investors like polestars: Where is the value? Where is the money going?
At a global level, the energy sector is cheap compared to the broader equity market. In the U.S., the current valuation is lower than the average level since 1986, comparing the sector’s price with its asset value, cash generation or earnings power.
Energy stocks are also unloved and under-owned by institutional investors. Bank of America Merrill Lynch (BofAML) Global Research’s Global Fund Manager Survey shows that the sector is the second-most unloved asset, barely preferred to Emerging Markets. Much of this dislike is predicated on the expectation that energy prices will decline. Francisco Blanch, Commodity Strategist at BofAML Global Research, differs on the degree to which oil prices may fall, expecting them to hover around current levels for the next few quarters. We also anticipate energy demand remaining relatively strong given our expectation for the global economy to continue expanding through the balance of this year, fuelled by corporate capital expenditures and consumer spending that is moderate but steady. At the broadest level, the energy sector reflects the cycles of economic growth.
Other investors are underexposed to energy for a different reason: They are chasing high-dividend stocks. Savita Subramanian, Equity Strategist at BofAML Global Research, sees those stocks as expensive. For investors who can aim not just for dividends but for total return — capital appreciation plus dividends — she recommends sectors like those highlighted by our TEAM USA theme — Technology, Energy, Autos and Manufacturing. These areas of the market provide greater potential for dividend increases as economic growth rebounds, business confidence remains resilient and companies increase cash returns to shareholders. Energy stocks, in particular, offer potential for growth in dividends and share repurchases due to improving cash flows.
Beyond these value and flow aspects of the energy story is the potential for energy stocks to insulate portfolios from a broad rise in energy prices. The relative performance of the stocks closely tracks energy prices. With geopolitical risks expected to remain prominent features of the investing landscape, we believe portfolios should be positioned for the possibility of higher oil and gas prices.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)