Via ConvergEx's Nick Colas,
The Energy names in the S&P 500, as measured by the S&P Energy Select Sector Index, haven’t broken their August lows in the recent downdraft for the group.
That’s surprising for two reasons.
- First, spot crude prices certainly have – a $36.52 low price today versus a $38.24 low on August 24th.
- Second, December is typically the month where investors harvest tax losses by selling losing positions and the Energy sector has a bumper crop of such candidates.
Today we look at the worst performers in the worst sector of the S&P 500 – the energy stocks that have most underperformed their peers in the space. As a subgroup, the Oil & Gas Pipeline names bring up the rear, with an average YTD return of negative 42%, led by Kinder Morgan (KMI, down 60%). The Independent Oil & Gas Companies follow, down an average 35%, with the three worst performers of this large subgroup Southwestern (SWN, down 75%), Chesapeake (CHK, down 77%), and CONSOL (CNX, down 80%) all hit by high financial leverage and short sellers (18-45% of shares shorted). Among the Drillers, down an average 37% YTD, Ensco (ESV, down 50% YTD) is the worst performer. We expect to see more volatility in the Energy sector through the next 2 weeks as tax loss selling reaches a crescendo.
We are all slaves to our experiences, and today’s note comes from two of my own:
The first large equity issuance I worked on as a brokerage analyst was to sell $140 million of stock for an almost bankrupt Chrysler Corporation back in 1991. Car sales were at recessionary lows – an 11 million unit annual selling rate – because, well, there was a recession in the aftermath of Iraq’s 1990 invasion of Kuwait and the resultant spike in oil prices and geopolitical uncertainty. The deal went off at $5.25/share, and the team spent some of the next day wiring money directly to Chrysler parts suppliers that hadn’t been paid in a while. The Grand Cherokee launched shortly thereafter and the company was saved. Selling the stock had been no small feat, since the company had been forced to do everything from cancelling its dividend to mortgaging a new headquarters/R&D facility before it was even built. The eventual sale price to Daimler-Benz in 1998: $48/share. Good trade.
Many years later while working at a large hedge fund as a PM, the guys opposite me in the room spent most of December buying up a basket of names that had underperformed dramatically during the year. By December 31st their portfolio looked like a menagerie of stray cats and dogs and other hairy animals of uncertain parentage. When I asked what they were doing, they explained that the “January effect” of stocks generally doing well in that month comes in part from forced tax loss selling of losers in December. Once the calendar turns, the selling pressure lifts and these underperforming stocks tend to bounce. They weren’t the first to figure this out, but it requires having great flexibility – and intestinal fortitude – for a professional money manager to show such a portfolio at the end of the year. Sometimes this strategy works, sometimes it doesn’t, but it is one some hedge funds use to this day and the academic work on the “January effect” is well known.
The current intersection in market’s Venn diagram of “Fundamentally challenged sector” and “dramatic underperformance” is, of course, Energy. The market cap weighted index of the Energy names in the S&P 500 is down 21.2% year to date, the worst of the any of the 10 major industry groups in the 500. The next worst performing group – the Utilities – is down less than half that amount: 9.8%. Put another way, if the S&P 500 had no Energy exposure the index would be up just over 1% on the year, rather than down 0.5% as of today’s close.
It could be worse, however. Spot prices for crude oil broke to new lows this week, and today’s closing price of $37.33 is 2% lower than the August 24th low of $38.24. At yet the Energy Select Sector index – that market cap weighted basket of Energy names in the S&P 500 – hasn’t broken down this week. It is actually 6% higher than its August 25th low. And, as noted, December is the month where hedge funds, separately managed account managers and individual investors sell their losers to offset the capital gains of other, more profitable, trades. This group has, of course, dramatically underperformed December month-to-date – down 8.3% versus the S&P 500 1.6% decline. It’s just that with the commodity breaking down it could have been – or could still get – much worse.
Thinking through how to understand the “Worst of the worse” names in the large cap Energy sector, we put together a quick spreadsheet (see the attachment to this email for the work) that has the following information:
- Name, symbol, weighting in the sector index, and YTD performance for all 40 Energy stocks in the S&P 500.
- Total Debt/Equity as of the most recent quarter, to assess basic financial stability
- Short shares as a percent of total float, to understand market psychology on the name
- Price to book, as a measure of valuation in this “Hard asset” business
- Most current quarter EPS, to see recently reported earnings power
No surprise, but the Oil & Gas Pipeline names have the worst average YTD performance at negative 42%. Kinder Morgan (KMI, $16.81) is the worst performer with a 60.3% decline. The company was in the news today for cutting its dividend from $0.51/share to $0.125/share giving it a stated yield of 3.0%. The stock rallied 7%, and that new dividend looks closer to last quarter’s reported EPS of $0.19 than the old payout. Worth noting is that shares short for the Pipeline names is low – 2.4% – and KMI has 3% shares short.
For large swaths of red colored YTD performance, however, the Independent Oil & Gas names are the place to go. Of the 19 names in the group, only one is up on the year: Newfield Exploration. The average decline for the group is 34.9% and there are four names down over 50%: Murphy Oil (MUR, down 54.8%), Southwestern (SWN, down 74.5%), Chesapeake (CHK, down 77%) and CONSOL (CNX, down 79.6%). Both Southwestern and Chesapeake have higher than industry average debt to caps (105% and 255%, versus an average 77%) and those two plus CONSOL have 18-45% of their shares shorted.
The Drilling and Exploration companies are also down more YTD than the Energy group as a whole, with the four names here an average of 36.9% down on the year. The worst performer is Ensco (ESV, $14.86). Shares short are 10.5% of the float, with Transocean (RIG, $13.07) actually showing the highest ratio in this subgroup: 30.8%.
We’ll close out on one surprising point for readers less familiar with the Energy names: one subgroup is up an average of 30.4% on the year, trouncing the S&P 500 and even the S&P Tech sector (up 5.4%). It is the Refining & Marketing companies, since their costs go down as crude slides but their end markets hold up long enough to capture the margin spread. The two best performing names are also the largest in terms of market cap in the space. Valero (VLO, $69.88) is up 41.2% on the year, Tesoro (TSO, $107.77) is 45.0% higher.
In terms of whether or not the “Biggest Loser” names we’ve highlighted here have any merit as a tax loss trade into 2016, the answer comes down to where – and when – you think crude oil prices settle out.
Yesterday’s reversals in both oil and the market as whole prove out that point. Everything was great until it wasn’t. That’s the most important takeaway – and the single message – of this note. As WSJ notes,
We’ve written about how December is historically the best month for stocks, and how equities typically trend lower in the first part of the month before Santa shows up in the latter half, fueling stocks into the end of the year. Over the past 20 years, the S&P 500 has slid an average 0.3% from the end of November through December 15, according to Bespoke Investment Group. It’s increased an average 1.7% from the middle of the month through the end of the year though.
“As long as the market can hold its November lows between now and mid-month December, then the market is still on track for a typical yearend rally that has historically commenced around mid-month,” said Jeffrey Hirsch, editor of Stock Trader’s Almanac.
Tax-loss selling and year-end portfolio restructuring are to blame for the weakness early in December, said Mr. Hirsch. Tax-loss selling is when investors sell securities at a loss to offset capital gains taxes on winning investments.
Volatility in the Energy sector isn’t over yet, with the calendar for tax loss harvesting set to play a role this month.