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Energy Stocks Are the Place to Be if Equity Markets Begin to Sell


The energy sector has been a preferred investment recently due to geopolitical conflict, and lower US interest rates.

Outperformance of the energy sector, compared to the broader market, could lead to buying pressure throughout the upcoming earnings season. Demand for energy stocks began last month when tensions in Ukraine rose, while US interest rates declined. Improvement in the price of oil, alongside declining results expectations for the S&P 500 Index (INDEXSP:.INX) this quarter could set up oil companies with earnings estimates that they will have no problem surpassing.

Crude oil futures finished March on a strong note as geopolitical tensions between Russia and Ukraine lingered. The immediate threat of a second Cold War has diminished, but the risk that conflict could quickly escalate, affecting Russia's oil and natural gas supplies, keeps a bid under prices. Russia claims that it will soon pull several hundred troops away from the Ukrainian border, but US officials warn tens of thousands of Russian troops may remain in place.

The chart below of United States Oil Fund LP (NYSE:USO) over PowerShares DB US Dollar Index Bullish (NYSE:UUP) highlights oil's price appreciation throughout the first quarter of 2014. Oil is used in a ratio over the dollar as a way of pricing the commodity in US currency. The strength of the commodity should translate to higher profits for energy companies as the sector begins to release results the next few weeks.

Loose US monetary policy is also a reason that oil, among other commodities, has been bid higher. To convey the story properly it is easiest to follow the chart of iShares Barclays 1-3 Year Treasury Bond Fund (NYSE:SHY) over iShares Barclays 20+ Year Treasury Bond (NYSE:TLT) from last spring. The indicator represents the US Treasury yield curve, and rises in value as monetary policy is tightened.  Previous Federal Reserve Chairman Ben Bernanke hinted last May that the Fed was considering reducing stimulus later in the year. This caused a spike in the yield curve lasting until the summer months as investors began pricing in an end to easy money from the Fed.

Interest rates remained elevated for a while, until weak economic data at the turn of the year led to speculation that the central bank would not actually raise its benchmark rate for a year or two. As the yield curve indicator has fallen the past few months, the dollar has followed it lower. Lower interest rates mean that commodities priced in the US dollar have become more affordable, and thus is a reason oil has risen considerably the past few months.

This has all translated to strength in the energy sector. The indicator below represents the relative strength of energy stocks to the broader market, and is comprised of the ratio Energy Select Sector SPDR (NYSE:XLE) over SPDR S&P 500 ETF Trust (NYSE:SPY). Fear of stimulus cuts and tighter US monetary policy led energy stocks to lag equity indices for most of 2013. The indicator, however, bottomed the first few months of this year, then began to outperform most other US equity sectors in March. This brings about the question as to whether all of the indicators shown in the article infer that one should invest in energy stocks right now. The answer involves some discretion.

Equity markets are beginning to form topping patterns, signaling that we could see substantial selling pressure over the next few months. Although I have laid out the positives of why energy stocks will have solid earnings in this article, weakness in a number of other sectors could drag energy down with it. There are patterns, though, of individual companies in the market that look strong, and may buck the trend if equity indices do start selling off.  If you remain undeterred at investing in the market now, then the energy sector could be your best bet, but again, discretion is important.

Andrew Sachais' focus is on analyzing markets with global macro-based strategies. He takes into consideration global equity, commodity, currency, and debt markets. Sachais is a graduate of Georgetown University, where he earned a degree in Economics.

Follow Andrew on Twitter: @MacroInsights
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