Energy Stocks, US Equity Volatility

By admin_45 in Blog

Two Data items to discuss with you today:

#1: US Energy stocks are our highest conviction idea, so let’s review two ways to play that theme: XLE (the Energy names in the S&P 500) and PSCE (the Energy slice of the S&P 600 Small Cap Index). Both Nick and Jessica own PSCE, but it is highly volatile, so XLE may be better for investors with lower risk appetites.

This is going to sound like an over-simplistic investment rationale but hear us out: neither XLE nor PSCE is back to pre-pandemic price levels. This strikes us as overly pessimistic. Oil prices (WTI at $73) are already closing in on 5-year highs ($74) and the global economy is only just now starting to hit its stride. We understand that carbon-based energy is not a long run growth story, but it is absolutely a here-and-now recovery story.

Against that backdrop, consider the following:

• XLE trades at a 27 percent discount to its 5-year high ($54 now, $75 then). Even if you haircut the old high by 10 percent to incorporate a lower sustainable valuation, that’s still a $68 price target or 26 percent upside from here.
• PSCE trades at a 65 percent discount to its 5-year high ($8 now, $22 then). Even if you give this group a 50 percent discount to prior cycle valuations, that is an $11 price target or 38 percent above current prices.

Now, one might reasonably wonder if global carbon-based energy consumption will really come back, so consider this graph from the US Energy Information Agency. It shows expectations of a complete recovery by 2022, with production surpluses only coming next year. Also worth noting: that y axis is in millions of barrels a day – this is not an industry at the precipice of extinction.

One final point: keep in mind that many popular ESG-focused US equity funds own traditional Energy names. ESGU (an $18 bn iShares product) owns ExxonMobil, Chevron, and ConocoPhillips. USSG (a $3.8 bn Xtracker ETF) owns Marathon and Phillips. Why? One likely reason is that index constructors know that when Energy stocks move they can be material to portfolio returns.

Takeaway: even if the Energy sector ends up having a lower structural valuation over time, we think there is still enough of a margin of safety to make this group investable.

#2: Every month we like to look at something related to implied volatilities – the amount of future price churn imputed by options markets. The most commonly cited measure here is the CBOE VIX Index, but you can use the same Black-Scholes math to calculate the implied volatility of any financial asset where options trade.

This chart shows the CBOE VIX Index (black line) as well as the implied vols for the NASDAQ 100 (red line) and Russell 2000 (blue line) back to 2004:

Note that the blue line (Russell 2000 small caps) generally holds the topmost position. Since implied volatility closely tracks actual volatility, that means that US small caps are actually the riskiest of these three asset classes. Yes, more than the NASDAQ 100. That is true even now: the implied volatility of the Russell is 26 as of yesterday versus 21 for the NASDAQ and just 17 for the S&P 500 (VIX).

Also worth a mention: the post-Financial Crisis period saw 2 volatility aftershocks, visible to the right of the grey recession bar. The first was the 2010 Flash Crash and the second was the Greek debt crisis. The first was a hiccup: the S&P returned 15 percent in 2010. The second was not: the S&P only posted a 2 percent return in 2011.

Takeaway: US equity volatility has come down over the past year just as it did after the Financial Crisis, so while markets may seem sleepy just now that’s actually in line with historical precedent. But – and it’s a big “but” – history also shows that can change quickly.