It’s funny to hear people say nothing is working in this market. In fact, markets are working almost exactly as they ought to given the macro backdrop. What is not working is passively buying financial assets at the most extreme valuations in history. But should that really be surprising to anyone who actually still uses their brain?
The Fed is unwinding the most aggressive monetary experiment in modern times and stock and bond prices are falling; short selling has thus been very profitable. Inflation is raging in reaction the aforementioned monetary orgy and the purchasing power of the dollar is eroding; commodities indexes are up this year more than twice the rate of inflation.
These things are working far better than they normally do; they just aren’t the things that investors have come to believe in the way they have come to believe, with unwavering faith, in passive investing. But perhaps that unwavering faith is now starting to waver a bit, for the first time in quite a while.
In fact, it would be remarkable if the worst market for a 60/40 portfolio in 100 years didn’t inspire at least a bit of introspection directed at the blind faith in passive investing. Still, it’s difficult to argue that investors have made any real shift at all from passive investing to the sort of thoughtful approach that would lead them to what is, in fact, working.
The energy sector, for example, is still just 5% of the S&P 500 Index despite the fact that it has outperformed heroically, both in terms of stock prices and earnings. At the oil price peak in 2008, it was more than triple its current weight. Before the current commodities super cycle is over, we’re likely to see it reach similar heights in terms of its weighting in the index once again.
Rather than embrace the energy trade, however, investors are actually betting heavily against it. The Wall Street Journal reports, “More traders are betting that energy stocks’ big 2022 rally won’t last. Short interest in U.S. energy stocks has risen to 3.9%, the highest level since October 2020, according to S&P Global Market Intelligence.”
This is fascinating for a number of reasons. First, despite the fact that the energy sector is the best performing sector in the market this year and last, it trades at its cheapest valuation relative to the broad market in history. This would be understandable if the sector were seeing peak earnings but that is just not the case.
The oil price has held above $80 per barrel amidst the largest release (by far) from the Strategic Petroleum Reserve in history, a surge in the dollar that is also historically very rare and an unprecedented shutdown of large swaths of the Chinese economy. That the oil price didn’t crash as a result of all of this is a huge tell. Each of these trends will inevitably come to end sooner or later and what will oil prices do when they all switch from headwinds to tailwinds?
What is likely behind the relative strength in the oil price lately is a simple supply/demand story. Demand, outside of China, remains as strong as ever while supplies are dwindling as a result of the dramatic lack of investment over the past several years.
That failure to invest was originally just a natural reaction to the oil price crash in 2014 which itself was the result of over-investment (made possible by easy money after the GFC) in the years prior. The ESG push in recent years exacerbated the trend by making any investment in the fossil fuel industry taboo. And now the Fed has dramatically raised the cost of capital making investment in energy supplies prohibitive.
This lack of investment means supplies will likely be limited for years to come. Of course, there is also the possibility that no amount of money could alleviate the supply issue today. Emmanuel Macron inadvertently revealed to the world that the Saudis simply have no more spare production. Is it so hard to believe that the recent OPEC+ decision to cut production in the midst of a global energy crisis was not a discretionary one as most seem to believe?
At the same time, the number of new wells here in the U.S. has collapsed over the past couple of years as the trend towards “high-grading” has largely run its course. During the bear market in oil prices of the past several years, producers focused their capital on only the most productive and profitable wells. As shale wells deplete much faster than traditional ones, this means that those left uncompleted today are only the less productive wells.
Together, rather than the predictions of peak oil prices that were popular a few years ago coming to fruition, it’s very possible these trends mean we are now witnessing peak production. If so, the oil price is only headed much higher in the years to come. And rather than peak earnings for energy stocks, the recent surge is only the beginning of a new trend.
Ironically, energy stocks trade at an average of just 4.4 times enterprise value-to-EBITDA even as they rapidly pay down debt. With the bullish fundamental backdrop noted above paired with the dramatic valuation discount to the broad market, it should be brutally obvious why someone like Warren Buffett is buying Occidental Petroleum hand over fist.
And as Buffett explained near the peak of the last commodities super cycle, “what the wise man does in the beginning, the fool does in the end.” The wise man is clearly still buying heavily (not only Mr. Buffett but insiders at many energy companies, as well), implying we are far closer to the beginning of the bull market in energy than the end.
Moreover, the fools, still wedded to the idea that “thinking is a waste of energy,” haven’t even sat up to take notice yet. And that creates tremendous opportunity for those of us still trying to put all that gray matter between our ears to good use.
