Tuesday, July 30th, 2013

The Black Stuff

In recent weeks our sector reports have noted a significant improvement in the probability curve of the Energy sector relative to the rest of the index. The most noticeable effect has been in the US, but we have made the same comment about Pan Europe and the UK. There is no great secret about the cause. The Goldman Sachs Oil Index is up by 19% on a total return basis, since the trough in late April, despite dropping by over 2% last week.

Just because the cause is obvious, it does not mean that it is not important. There are plenty of occasions when the oil price rises and the energy sector does not respond – the period from October 2011 to March 2012 is a good example. What happens to the energy sector relative to the rest of the equity market depends just as much on interest rates and earnings growth, as it does on the level of WTI or Brent. So when oil prices are rising, and our commodities model has oil as it highest single commodity exposure and the energy sector is starting to outperform in the US and Europe, it is wise to pay attention.

As regular readers know, we hate anything that looks like a forecast. The Harlyn process was developed as a way of listening to the market, not telling it what to think. The conclusion of this blog is not that the oil price will carry on rising or that the energy sector will continue to outperform. That is for the individual investor to decide. Our job is to gauge the strength of the move so far, and to identify its knock-on effects.

So here goes.  (1) This week we formally upgrade the US Energy from Underweight to Neutral. If present trends continue, upgrades in Europe will follow soon. The recent acceleration in return per unit of risk has been more powerful, but the sector started from a lower base.  (2) The Materials sector has already begun to respond in the US and the Eurozone, but not the UK. This is because the make-up the sector is different. In the UK this sector comprises mainly mining companies. In the US and the Eurozone there is a far higher exposure to the chemical sector, which tends to be a beneficiary of rising petro-chemical prices.  (3) The strength of the energy sector has already started to have an impact on the ranking of individual countries relative to a world index. Norway, Canada and Russia have each shown big improvements over the last four weeks.  (4) Energy is too large a sector to be upgraded without having an impact on at least one major sector. It doesn’t look like being Financials, so it has to be one of the defensives, with Consumer Staples and Healthcare as the two prime suspects.

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