Just Knocked Down a Few Pegs

 | May 24, 2012 | 10:30 AM EDT  | Comments
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Stock quotes in this article:

xle

,

spy

I was struck recently at how disparate the fortunes of various sectors have been so far in 2012. On the one hand, Technology and consumer discretionary stocks have posted healthy gains so far this year, rising by 10% or more. Other corners of the market have been less fortunate: the Energy Select Sector SPDR (XLE), for instance, has fallen by about 5% in 2012, putting it at the back of the sector pack.

As I'm handicapping the race for the remainder of 2012, I like this horse that's drifted to the back as a result of fading interest from investors. The XLE was recently trading at a forward price-to-earnings multiple of only about 10x. By comparison, the Consumer Discretionary SPDR (XLY) has a forward P/E of about 15x, and the broad-based SPDR S&P 500 (SPY) is going off at about 12.5x forward 12 months earnings. In other words, energy stocks are trading at a meaningful discount to their peers in the consumer discretionary sector, and well below broad-market multiples.

Over the last several years, the energy sector has endured some relatively dramatic swings. The biggest risk at present would be a potential double-dip recession, as this would hit the energy space much harder than it would other areas of the market. If the economy begins to contract once again, we would presumably see a big drop-off in demand for petroleum and other energy products.

The recent performance in energy stocks would lead you to believe that this sector has fallen on hard times. But there's a disconnect from the economic reality here. By all accounts, the U.S. oil industry is firing on all cylinders. North Dakota production has shot through the roof recently, and the state is optimistic that it could double again in the next few years. (That would challenge Texas as the top producer among U.S. states). Further, very little has been made of the massive oil reserve sitting under federal lands in Colorado, Utah and Wyoming. That collection of up to 1 trillion barrels of oil could make the U.S. a major player in the global oil business if technologies allow for the extraction.

The discoveries of substantial natural gas reserves in the U.S. have been a noteworthy development recently as well, and one that I believe will be a net positive over the long run. U.S. oil companies generally have meaningful operations in the natural gas space, too, positioning them to thrive if the so-called "fuel of the future" actually pans out. The U.S. oil and gas industry is alive and well, so it's perplexing that pricing multiples have been depressed so substantially -- especially considering that oil prices are still hovering around $90 per barrel.

Thanks to investor aversion so far in 2012, XLE is now available at a substantial discount, making it an interesting value play that has the potential to deliver some huge returns in a relatively short period of time. Energy has been knocked down, but certainly isn't out.

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