Energy stock is the best sector to invest in right now

Stock market can absorb $130 oil, JPMorgan’s Kolanovic says

There are bulls, and there are bulls — and this highly regarded JPMorgan strategist has just made a provocative call on the energy prices the stock market can absorb.

According to Marko KolAccording to Marko Kolanovic, markets would be “fine” with $130 oil and a U.S. 10-year Treasury yield 1.588% above 2.5%.

Markets have struggled in reaction to a surge in bond yields, that in turn has been driven at least in part by the European energy crisis that has spilled over into crude. Though up on Wednesday, the tech-driven Nasdaq Composite has retreated 6% from its record high set in September, and the S&P 500 was 4% below its peak.

To Kolanovic, the chief global markets strategist at JPMorgan, the current energy and supply chain issues do not jeopardize but reinforces its rotation thesis. He says green policies have contributed to the current crisis, as it’s diverted capital from fossil fuel development, though at a certain point higher energy prices will boost traditional energy capital expenditure.

Oil at $130, or even $150, won’t derail the economy, given the health of consumer balance sheets and total oil expenditures, he argues. “Consumer balance sheets are now in a strong position and some reallocation of expenditures towards energy would not set back the economy and equity markets. At the low end of the income range, potential strain from high gas prices could be an issue, but it can easily be addressed with a small fraction of current stimulus plans,” says Kolanovic.

Investors should consider hedging for higher oil prices. That could come from going long commodities and short bonds, going long energy stocks, or going long value and short growth. “The most likely outcome of the current energy crisis is increased production at significantly higher energy prices, which would stabilize the global economy and energy infrastructure, but also temporarily slow down the energy transition,” he says.

He leaves the “high-multiple growth sectors” like the Nasdaq from his buy-the-dip advice. “Our highest conviction ideas remain energy (equities and commodity), materials, industrials and financials, and reopening, COVID-recovery, reflation and consumer themes,” said Kolanovic.

Energy stock is the best sector to invest in right now

It's not too late for investors that missed out on this year's best-performing sector to gain some exposure, JPMorgan said of energy stocks in a note on Thursday.

The energy sector is up about 50% year-to-date, nearly triple the S&P 500's 17% gain over the same time period. But there's still room for energy stocks to play catch-up to the broader market when looking at a longer time horizon, the bank noted. Since 2014, the energy sector is lagging the broader market by a whopping 183%.

JPMorgan sees gains continuing for energy stocks as a supply crunch pushes oil, natural gas, and even coal prices through the roof. Those prices could continue to creep even higher, as JPMorgan sees oil potentially surging to $130 per barrel.

The energy sector offers an attractive risk vs. reward profile to investors thanks to three key reasons: low valuations, improving fundamentals, and increasing capital returns, JPMorgan said.

In fact, valuations of energy stocks are so low that the sector represents only about 3% of the S&P 500 today, down from about 20% at one point, the analysts noted. That leaves significant runway for the sector to increase its value as favorable economics wash over energy companies amid a surge in oil prices.

"As is usually the case with commodities, we expect the energy recovery to be swift and more extreme than post-bust rebounds seen in other asset classes such as commercial real estate during the 1990s, dot.com during the 2000s, and financials/housing during the 2010s," JPMorgan said.

The bank said investors looking for the most upside potential in the sector should buy small-cap energy stocks. That's because they have higher sensitivity to rising oil prices, are undergoing a balance sheet recovery, and are potential merger targets as larger peers look to build up their reserves.

And many of the risks that have scared investors out of energy stocks over the past few years, like regulations, the rise of ESG investing, and a surge in electric vehicles, are actually catalysts for buybacks and dividends.

Those factors are "helping bring much needed discipline to the sector with a focus on reducing debt and returning excess shareholder capital rather than higher market-share and production," JPMorgan said.