This May 2020, Our Dynamic Tilt Tilted Away from Energy

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Because forward price-to-earnings (P/E) is calculated by dividing the current price by the expected future 12-month earnings, a higher P/E ratio either means that the price is higher, the expected earnings are lower, or both.

In the case of energy, Vanguard Energy Index Fund ETF (VDE) dropped -18.31% from an adjusted close of $61.85 on March 2, 2020 to $50.53 on April 31, 2020.

Normally a price drop that significant would mean that the forward P/E ratio gets smaller. This is what happened with U.S. Mid Cap and U.S. Small Cap, both of which are down over -20% from their March prices and are now showing an April 31 forward P/E below their averages.

However, at the end of April 2020, the forward P/E of the MSCI USA IMI Energy Index was 96.39, almost five times larger than its historical average. This extremely large forward P/E is descriptive of Energy’s lost expected earnings.

The news is streaming live updates about a global pandemic, and we are all sheltered in place. Children are home as schools and daycares are closed. Students are home as dorms and lecture halls sit empty. Workers are home as office buildings limit commuters. Our hair is growing longer as hairstylists are forced to furlough. Groceries stores are picked over as shoppers are encouraged to limit trips to the store. Life is very different, and Energy companies have been hit hard by those changes.

As MarketWatch reported, the May oil futures contract is set to expire negative, meaning companies would be paying people to take oil off their hands. In “The oil market is running out of storage space and production cuts loom ,” MarketWatch reports it this way:

Current oil production is about 90 million barrels per day, but demand is only 75 million barrels per day. …most analysts are expecting the U.S. to reach full oil storage by late April or early May, with global storage reaching full capacity by early June,” said David Grumhaus, co-chief investment officer at Duff & Phelps Investment Management.

With storage running tight, negative rates for a single month is something unique to the futures market. Energy funds, although not futures, are obviously affected by the prices of their production.

In addition to regularly rebalancing client portfolios, we analyze forward P/E ratios monthly to overweight sectors where earnings appear cheap and underweight those where earnings appear expensive based on historical valuations. We call this analysis dynamic tilt.

Sometimes it is difficult to be a contrary investor because it means buying or holding at a time of maximum pessimism and selling at a time of maximum optimism. However, our dynamic tilt is one more way to systematize being a contrarian, removing some of the emotion and helping achieve a greater rebalancing bonus for doing so.

In the case of Energy, while many may sell Energy completely during this time of low expected earnings, our dynamic tilt for the month is suggesting that we set our allocation to the sector at only 50% of our static targets and lean our Resource Stock sector allocation instead towards Foreign Real Estate, which has a forward P/E ratio currently below its historical average.

For many whose Energy sector has experienced large losses, lowering your sector allocation might effectively mean holding onto the shares that you currently own (perhaps with light trimming for tax-loss harvesting) without adding more and then directing new purchases to other sectors.

Energy is normally a resilient category. Historically, Energy fund prices have had a strong reversion to their mean. This means that low returns in Energy are historically generally followed by high future returns, and vice versa. By setting a target allocation to Energy and diligently trimming and filling it to keep it on target, on average rebalancing will help you to buy low and sell high.

In this case though, the expected earnings suggest that we don’t try to buy low just yet. The forward P/E ratio suggests that, even at these low prices, Energy is overvalued. That suggests that Energy may be in for more losses before any recovery. I would guess that Energy will eventually recover to a higher price after all these stay-at-home orders are lifted, but no one, us included, can predict future results or successfully identify market tops or bottoms.

Our Investment Committee is continuing to monitor Energy to see if any institutional, governmental, societal, or corporate changes will remain after this pandemic which may alter this category enough to suggest that it is no longer a good investment. For the time being though, we still feel that we have enough historical data for Energy to justify its place in our portfolio design. For this month, we will elect to simply hold onto the investments, as the data suggests is wise.

Photo by Markus Spiske on Unsplash

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine