Energy prices risk derailing equity advanceEnergy prices risk derailing equity advance

By Michael Mackenzie

Published: March 31 2011 19:01 | Last updated: March 31 2011 19:01

Sitting on your hands may not win plaudits among the bold and the brave, but it has proved a winning formula for US stock market investors this year.

A sharp jump in oil prices has propelled energy companies to a second successive quarter of impressive gains, making them the best performing sector in the S&P 500.

Since the start of the year, and thanks in large part to the turmoil in the Middle East that has sent crude to its highest level since 2008, energy stocks including Chevron, ExxonMobil and Marathon Oil have been among the market’s biggest gainers in the first three months of the year. The sector has risen 17 per cent, eclipsing other industries to lead the S&P 5.6 per cent higher.

The problem for equity investors is that energy’s sustained run, after a rally of 21 per cent in the past three months of 2010, is just the plus side to an oil supply shock – Libya – that threatens to cast a shadow over the market. Higher fuel costs are predicted to erode profit margins for many other companies and sap consumer spending.

Indeed, Jack Ablin, chief investment officer at Harris Private Bank, warns that higher energy costs are now “the biggest factor weighing on margin expansion”.

One of the most important drivers for equities, therefore, in the second quarter will be whether commodity prices pull back. Stocks exposed to discretionary spending could benefit if the bull run in energy and raw materials runs out of steam.

Jim Paulsen, chief investment strategist at Wells Capital Management says breathing space may be at hand. A slower pace of growth in the world’s emerging markets should translate into a retreat for commodity prices.

“Commodities are peaking here and we should get some relief,” he says. If that is accompanied by better jobs numbers – the latest US non-farm payrolls are due today – then stocks have room to rally more broadly, says Mr Paulsen.

Trading post

Jamie ChisholmIt’s the first day of the month and the first session of the quarter. Investors will have to digest the raft of global PMI manufacturing surveys and the “crucial” US non-farm payrolls data. And if all of that didn’t already keep traders on their toes, it is also April Fools’ Day. Careful now! The turn of the calendar comes as the S&P 500 sits poised to challenge cyclical highs. Colleagues address some of the fundamentals that have been powering stocks of late. But for ultra-short term traders technical factors are just as important.

Here are a few. After the previous seven months had averaged a first-day S&P 500 gain of 1.5 per cent, March duly delivered a 1.6 per cent drop. Thus traders may be more wary of this previously supportive “calendar bias”. Bearish.

The bounce from the Japan earthquake lows has been swift, but the S&P’s relative strength index suggests the market is not overstretched. Bullish.

Indeed, the S&P is above its 50- and 200-day moving averages, while the MACD momentum indicator points to the start of another up leg. Bullish. But, for contrarians, the Vix, at 18, is dipping back towards complacency levels. Bearish.

Other strategists, though, are less confident about the wider market’s prospects. Despite a recent run of robust economic data and solid corporate earnings, the prospect of an end to the Federal Reserve’s second round of “quantitative easing” – its huge bond-buying programme to stimulate recovery – could cap further gains.

And, as oil prices have climbed back towards the record high set three years ago of almost $150 a barrel, some economists have begun lowering their growth expectations for the US economy in the first half of the year.

“Equities face considerable headwinds in the second quarter,” says Kate Moore, senior global equity strategist at Bank of America Merrill Lynch. “The market may have got ahead of itself. Rising oil prices, higher interest rates and downward revisions to economic data will weigh on the equity market.”

The signs of diminishing confidence in the rally, which at its peak took the S&P to more than double its March 2009 nadir, is already evident in non-energy stocks that did well last year.

Materials, for example is up just 3.6 per cent this year after a gain of 18.5 per cent in the fourth quarter. While industrials have done well again, they lag their rise of 11.2 per cent in the last three months of 2010. Technology’s 3.5 per cent gain in the first quarter is less than half its 10 per cent rally the previous three months.

“Sectors that led the rally since last August are now lagging as investors worry about the ability of companies to increase their earnings,” says Ms Moore.

One closely watched barometer will be the Dow Jones Transports Average, seen as a bellwether. This week, it climbed to a 52-week high, boosted by the performance of railways, which are seen as benefiting from more demand as fuel costs hurt truckers.

Yet, having risen more than 140 per cent since March 2009, the Dow Jones Transports has slowed to a gain of 3.3 per cent since the end of December.

Mr Ablin says: “A loss of momentum among this type of sector will be a prime indicator that the squeeze is ready to force the broad market lower.”

Already, the first quarter has seen a marked reversal for airlines, which are highly sensitive to higher energy costs. The Bloomberg airline index has fallen 7 per cent

The share prices for the big two delivery companies, FedEx, up 0.8 per cent for the quarter, and UPS, up 2.7 per cent, could also be useful leading indicators.

But, for all the uncertainty over the effects of higher oil prices, equities are still seen by many as a better bet than bonds this year. Ms Moore expects oil prices to peak in the second quarter. A retreat in equities would represent a buying opportunity for those who have added heavily to their bond holdings in the past two years. “We still see equities as outperforming bonds in 2011,” she says.

Confidence falls

US consumers are not feeling particularly buoyant at the moment and that is potentially bad news for companies banking on a sustained recovery. his week, the Conference Board’s consumer confidence gauge for March plunged to a three-month low. Consumers sharply lowered their expectations for future business activity, employment prospects and income growth. Meanwhile rising prices for food and energy pushed expectations for inflation over the next year to the highest level since October of 2008.