by Dan Hassey, Editor, Gold and Energy Investor.
The International Energy Agency just slashed its 2014-'15 demand forecasts and some forecasters are now predicting a warmer winter ahead.
These factors helped contribute to yesterday's nearly 5% slide in crude oil prices. On Tuesday, Brent and West Texas Intermediate crude fell to their lowest levels since 2010 and 2012, respectively.
Right now with oil dangerously close to $80 a barrel, it's tough to be an energy bull.
However, while we wait for our (very well-tested) patience to pay off, today is a good time to talk about energy as both a hedge and an asset that could lead to some very impressive gains for investors with a longer-term investing horizon.
Why I'm Not Worried About Crude's Price Plunge
Simply put: It's not only one of the best hedges around, but it can offer impressive returns in its own right -- both in the short and long term.
One of the key components of Portfolio Theory is the importance of diversification. According to academics, the theory suggests that all equities in a portfolio should be a negative correlation.
In other words, if you want to reduce risk, don't put put all your eggs in one basket.
Energy and gold are considered good diversification assets. That's because their returns are (generally) negatively correlated to the market.
For example, when inflation is rising, stocks tend to get hit -- but gold and energy tend to do well in those conditions.
And at today's deeply discounted prices, you may be asking ...
How Much Should You Invest in Energy?
The brokerage account average at the major brokerage firms (Merrill Lynch, Morgan Stanley and UBS) is around $400,000. Most of these investors also have a discount broker with the average size of around $80,000. So, the average retail investor has investable assets of about $500,000.
Of course, the size of your portfolio and risk tolerance should be part of the decision-making process when you're buying energy stocks, ETFs and options.
There are rules that some investors use regarding asset allocation:
No position should be more than 10% of a portfolio.
You should not have concentrated positions.
Each position should be the same dollar amount.
These rules do make sense, but I like to be a bit flexible regarding portfolio allocation.
I pay more attention to the size of the portfolio during each phase of the cycle. Again, at the beginning of a cycle, I am fully invested. Toward the end of a cycle is where I would seize profits and raise cash.
Despite the bearish trading activity, we are still in a bull market -- both in the broader markets and in the energy sector.
Market Cycles & Energy Investing
Markets tend to follow economic growth trends, but not always. Look at this list of bear markets:
For context, here is the definition of a bear market from the Wall Street Journal:
"The traditional definition of a bear market is a 20% decline from a previous peak with a combination of a broad-based market deterioration, with a negative backdrop of psychology, economic and corporate performance."
Now, the average bear market is near 30%.
This table shows how long each bull market has lasted:
The average bull market lasts about 4.06 years. This bull market is about 6 years old — longer than most.
Below is a long-term chart of a popular energy ETF: the Energy Select Sector SPDR ETF (XLE):
The first leg of the energy bull market started around 2003 and ended in 2008. During that time, it appreciated about 200%. The second leg of the energy bull market started in 2009, and appreciated about 150% as it enters its sixth year.
At the beginning of a bull market, it makes sense to be aggressive and fully invested.
However, as a bull market ages, it makes sense to be more cautious.
Most economic and market cycles end when the economy heats up and the Federal Reserve raises rates to slow the economy. The market normally overreacts and the bull market ends.
As the Federal Reserve ends QE3, it may starting raising rates in 2015. During this time, being more cautious makes sense.
Geopolitical risks have also risen (Middle East, the conflict between Russia and Ukraine).
Inflation is low as the economy is not strong enough for the Fed to raise rates too much. The economy could sustain its current growth for a few more years. However, this is not a normal economic cycle for many reasons including:
The U.S. economy is $17 trillion and it is harder to move the needle on growth
More global competition
The severity of the Great Recession
Too much debt, not enough demand
Stagnant wages
Too much regulation
However, there are still profits to be made ...
4 Ways to Invest During Energy Pullbacks
In the late phase of a bull market, it is harder to find undervalued stocks.
Look at the XLE chart again. At the start of the chart, the ETF was below $30; now it is close to $90 and nearly three times more expensive. It is harder to find bargains this late in the market cycle.
When I find the beginning of a bull market (similar to 2008-'09), I will be more aggressive and provide many recommendations.
The current weakness in the energy markets will give some opportunities to make recommendations. I am waiting for prices to find a bottom and base.
As this leg of the energy bull market gets long in the tooth, here are the strategies I have implemented in my Gold and Energy Investor service:
Take profits and raise cash — we grabbed gains in several long positions this year. Our buy list size is the lowest it has been in our 10-year history ... but as oil and natural gas bottom, this should change quickly.
Continue to look for the best dividend-paying energy stocks. Dividends pay you to wait for stocks, and the commodities that drive them, to go up.
Use shorter-term holding periods. But don't rush to sell the high-dividend-paying stocks you've been holding on to for years that you might own at a steep discount.
Use more caution. And that means being careful not just with what you invest in ... but how much you invest.
And no matter what the price of oil is, I prefer exploration-and-production companies. Here's why ...
Why Own E&P Companies?
I prefer oil to an oilrig, so I prefer to recommend E&P companies that own, develop and produce oil and natural gas.
The global economy needs three components for it to work:
Customers -- Investors can’t buy customers
Capital -- There are many ways to access capital (internal from profits or selling company assets, banks, debt and equity markets, private funding). Many countries can borrow from their government. An investor can invest in banks and Wall Street firms.
Energy (especially oil and gasoline) -- I believe investors need to own oil. It’s an essential, valuable, and depleting asset that the global economy needs.
Remember, capital is the blood, and energy is the food.
This means, I will be overweight in E&P companies. And I will look to recommend other sectors in the oil industry when they are deeply undervalued or have strong growth prospects.
Bottom line, investors need to invest in oil, especially when it is oversold and undervalued. Waiting for oil and energy stocks to bottom and then base is crucial. Stay tuned to this column, and I will let you know when I see that happen.
Good Gold and Energy Investing,
Dan Hassey.
Check out other post on this blog; you would love them.
Happy Reading!
Nwadu Obiora.
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