Energy and Mining Are Overlooking the Stock Market

Energy and Mining Are Overlooking the Stock Market

Soaring profits at oil companies and miners are outperforming the reality of the rest of the stock market, distorting Wall Street’s favorite valuation tool, the forecast price-to-earnings ratio.

The energy sector crashed and the expected earned gain for the S&P 500 this year falls from 8% to just over 1%, according to data from IBES Refinitiv. Take out miners and other commodity players too, and earnings for the rest of the market are expected to fall this year.

It’s the same for valuations: The S&P 500 is 18 times this year’s expected earnings, a low price but at least cheaper than the 22 times that prevailed at the start of the year. Take out energy and commodity stocks, however, and the valuation jumps back up to 20 times this year’s EPS, according to Citigroup data — suggesting less hope for those looking for cheap American stocks.

It’s surprising that such a small sector should have such a large effect—energy was just 2.7% of the S&P by value at the start of the year, and other commodity stocks even less.

There are two reasons. The first is simple: rising oil prices have pushed the energy sector up 4.8% of the S&P by value, making it more important. The second is more interesting, and gets to the heart of the question of how to use stock valuations: Oil stocks are the cheapest part of the market on price-to-earnings ratios. That means the energy sector’s earnings account for a much larger percentage of S&P 500 profits—more than a 10th—than its market weight suggests.

And when I say free, I mean it. The energy sector trades at just 8 times expected earnings for the next 12 months, while Marathon Oil is at just six times. These are valuations that are usually associated with dying companies, not with ever-more profitable businesses.

In contrast Amazon is at 80 times and Tesla at 56 times, the kind of super-extended valuations that can only be justified with fantastic growth prospects.

However, the oil valuations make perfect sense, because Amazon and Tesla are almost inverse : Profits are now at an all-time high but are expected to decline in the coming years as the price of oil falls elevated. The price of benchmark West Texas Intermediate oil futures declines the further out they mature, from $86 for the nearest contract until it stabilizes at $57 in 2030.

Windy oil profits are welcome for shareholders, but because few believe they will remain high, investors place a low number on them.

It’s a reminder to investors that valuation tools are just tools, and not a perfect guide to future returns. The PE ratio might make oil stocks look cheap, but only because the ratio is only a year ahead of what is almost certainly a temporary high in earnings – further out, the PE ratio is less attractive. Quite the opposite happened in 2020, when blackened oil prices (in short negative!) meant the sector traded at very high multiples of then very low earnings, which did not reflect that oil stocks were expensive .

Some companies are always in such a situation, but at the index level it usually washes out. Not so now, because the oil sector is making so much money that it can meaningfully change the valuation of the entire S&P.

The drop in this year’s non-commercial earnings estimates shows that some welcome reality entered analysts’ thinking over the summer as forecasts were cut. I’m still concerned that it’s far from enough, as next year’s earnings expectations are still elevated.

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The cuts to this year’s earnings forecasts hit hard in May. Since then, the post-energy growth rate has been reduced from 5% to 1%. But analysts continue to expect next year to be fine, pulling in 10% growth, which is not far from the 2023 growth expected at the start of this year.

If the economy has a soft landing, inflation comes down quickly and the Federal Reserve starts cutting rates, a new period of economic expansion could begin next year and earnings grow just as strongly. More than likely, the economy is at least flirting with recession and earnings sputter, with a reasonable chance that profits will be crushed by an economic downturn.

If my concerns are well-founded and earnings are lower than expected, it means that US stocks are more expensive than they appear. Whatever happens, the forward PE ratio is a less useful guide to future returns than usual.

Write to James Mackintosh at james.mackintosh@wsj.com

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