Morgan Stanley says there's one piece of the market you need to own as stocks run out of steam
- Morgan Stanley's equity strategists have said the strongest stock-market returns of this cycle are behind us.
- They believe investors will turn more defensive towards the end of this year, and see the energy sector as a beneficiary of that rotation.
Morgan Stanley's equity strategists think the bull market in stocks is riding into the sunset.
They still expect stocks to rise before this cycle is over, but say its performance will be led by fewer stocks and accompanied by higher risk.
As investors turn more defensive, the strategists believe that energy will be one of the sectors that benefits. They're betting that more efficient spending from US producers and further supply controls from the Organisation of Petroleum Exporting Countries should benefit energy stocks.
"We remain bullish on energy as a classic late cycle sector with oil price support and defensive characteristics that should buoy the sector as market leadership shifts more defensive later this year," Michael Wilson, the chief equity strategist, said in a note on Monday.
A part of this bullish call on energy hinges on the expectation that history will repeat itself. If this economic cycle is truly approaching its end, then energy stocks could once again play catch-up as demand for oil rises faster than supply.
A more immediate catalyst for energy stocks is the fact that oil prices are rising. On Monday, US oil prices topped $70 per barrel for the first time since late 2014. Brent crude oil, the international benchmark, topped $76 per barrel, higher than Morgan Stanley's oil strategists had expected prices to be by the third quarter.
The rebound in oil prices has helped the energy sector deliver the most S&P 500 earnings growth over the past year, and substantial growth since 2015.
"Not only have earnings been moving higher for energy, but the uncertainty around those earnings seems to have peaked as well," Wilson said. That's because analysts' earnings estimates are increasingly in line with each other.
"Declining analyst dispersion of estimates implies greater confidence on earnings achievability which should mean forecast earnings are rewarded with a higher multiple," Wilson added.
Wilson further noted that energy's price-to-book ratio is currently lower than its historical average. "We think the extreme levels of relative valuation are pricing in overly bearish expectations on trends that will take longer than the market expects to play out," he said.
Finally, unlike tech and other recent outperformers in the market, energy is not a crowded trade. "An under-owned energy sector with a small overall market cap weight could benefit from market rotations and flows in an outsized way as our late cycle thesis plays out," Wilson said.
The firm's top picks in energy include Continental Resources, Encana Corp., and Marathon Petroleum.