Musings: Energy Stocks Experience Difficult First Quarter

The S&P 500 Index experienced an 11.7% loss for the first quarter of 2009 while the index's Energy sector generated a slightly worse quarterly performance with a 12.1% loss. Of the S&P 500's ten industry sectors, only Technology produced a positive investor return for the first three months of 2009. In looking at the first quarter performance of the industry sectors, it is noteworthy how many of the sectors generated fairly similar returns. While Technology generated positive return, the Materials sector was close with only a 2.8% loss for the quarter. At the other end of the spectrum, Financials and Industrials each reported greater than 20% losses. Of the remaining six sectors, three produced almost exactly the same results of 8.5% losses while the balance of the sectors, including Energy, had losses ranging from 11.3% to 12.1%. The quarterly results were helped considerably by a strong and positive market environment in the closing weeks of the quarter.


Energy stocks have done better in recent weeks as crude oil prices have improved. For many energy companies highly dependent upon natural gas markets for activity, the steady decline in gas prices since last spring and the prospect of further gas price weakness due to chronic oversupply suggests energy stocks will continue to struggle in the stock market in the coming months.


The stock market rally of the past four weeks has been quite impressive. The lows for the Dow Jones Industrial Average (DJIA) and the S&P 500 Index coincided on March 9th. From then to April 9th, the DJIA was up 23.5% while the S&P 500 gained 26.6%. Measured from the same point, the AMEX Oil Index (XOI), the Philadelphia Oil Service Index (OSX) and the AMEX Natural Gas Index (XNG) have risen by 14.4%, 26.0% and 25.9%, respectively. The interesting point about the energy sector is that the lows were actually made a few days prior to the lows for the overall stock market indices - March 2nd for the OSX and XNG and March 3rd for the XOI. There doesn't appear to be a strong correlation between the rise in oil prices and the performance of the energy stocks since crude oil prices bottomed in mid February some several weeks ahead of the lows for the energy stocks.

Probably the most notable point is that measured over the entire period from December 31, 2008, through April 9, 2009, the DJIA was down 7.9% while the S&P 500 was lower by only 5.2%. In contrast, the OSX was up 14.9% and the XNG was slightly profitable at 0.9%, although the XOI was down by 8.9%. The only possible explanation we can offer for this difference in performance is that small market capitalization stocks generally have performed better than large market capitalization stocks. The OSX is generally composed of stocks that easily fall into the small cap arena. Does this show that stock market characteristics may have a greater role in performance than industry fundamentals? There is no doubt that oil service companies are facing weaker activity measures and increased


pricing pressure meaning that earnings for the companies will be declining in future quarters. Therefore, for energy stock prices to be rising investors must be counting on either a quick turnaround in the industry's fortunes or they are buying small company stocks with the belief that this market segment will achieve greater percentage appreciation than large cap stocks as investment funds flow into the stock market. We are happy with either explanation. What we are concerned about is the possibility that investors may have been driven away from the stock market due to the horrendous bear market devastation of stock prices over the past 12-18 month period.

It is interesting to note, based on the results of a recent investment analysis, that at any time from 1980 through 2008, if an investor owned 20-year treasury bonds and rolled them over every year, he would have beaten the returns produced from investing in the S&P 500 Index through January 2009. In fact, one can go back 40 years to 1969 and a 20-year bond investor still wins the return battle, but by only a marginal amount. This performance is quite striking as the 40-year period includes the very bad bond market period experienced during the high inflation period of the 1970s.

Starting in 1802, stocks have beaten bond returns by about 2.5 percentage points, which, compounded over two centuries is a huge differential. There were, however, periods during this two century span when bonds did beat stocks - the 68-year span in the early 1800s, the 20-year period around the Great Depression and this modern period. The challenge for equity investors is that increasingly comments and analyses are coming forward pointing out how stock market investors lost money over the past ten years, which is being used as an indictment of the "buy-and-hold" investment philosophy associated with long-term investors.


Therefore, the new investing mantra is becoming "buy bonds for the income security," although seldom is pointed out the risk of capital loss, which is quite high should inflation accelerate as a result of the government's economic stimulus efforts. The other view being expressed about equity markets is that investors should only be in the stock market as traders and not investors. This implies that 'news, views and rumors' may have greater influence on stock price performance than company fundamentals and/or its financials. If this latter view holds, then we could be looking at a permanent increase in stock market volatility.

We remain optimistic that investors will not withdraw from the equity market permanently. If they do, and we rate that risk somewhat high (although not the most likely scenario), equity valuations will suffer. Instead of valuations returning to the levels experienced during the past 10 years, we may instead be looking at valuations closer to those experienced in the 1970s in which price to earnings measures were in the single digits rather than the mid teens as in recent years. That will not be good for investor long-term returns.


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