Energy Cracks, Shares Rally Hard

Strong retail sales and falling crude prices give major averages a big boost despite energy sector losses.
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The recent rout in commodities had seemingly wiped away the market leaders of the January rally. But , that didn't seem to be worrying investors on Tuesday, as another big drop in energy prices coincided with news of a big rebound in January retail sales, spurring a sharp rally on Wall Street.

Strong retail sales -- the strongest since May 2004 and since December 1999 excluding autos -- revived buyers' spirits, helping investors reconcile with the idea that new

Federal Reserve

Chairman Ben Bernanke might sound hawkish during his first testimony to Congress on Wednesday.

Warm weather and gift-card redemptions apparently got consumers out of their homes and into shopping malls. Warm weather also contributed to another situation the market cheered on Tuesday: Crude oil prices dropped below $60 per barrel and gasoline fell to its lowest level in nearly a year amid rising inventories.

The idea that consumers are back in the game and will likely consume even more as energy prices drop benefited the economically sensitive sectors of the economy, such as consumer discretionary, industrials and technology.

The

Dow Jones Industrial Average

soared 136 points, or 1.25%, to 11,028, closing above 11,000 for the first time in over a month. The

S&P 500 index

rose 12.67 points, or 1.0%, to 1,275. The

Nasdaq Composite

gained 22 points, or 1.0%, to 2,262.

While the market gains were broad-based, retailers benefited the most, as the S&P retail index gained 1.9%. Among the biggest gainers,

Circuit City

(CC) - Get Report

rose 2.1% after Citigroup upgraded and raised its price target on the stock, while

Home Depot

(HD) - Get Report

gained 3.6%.

Target

(TGT) - Get Report

rose 1.6% even after it warned its results might be hit because of the snowstorm that covered the Northeast last weekend.

But does the tumble in energy prices mean the end of the energy sector's rally? The Amex Oil Sector Index dropped 0.8% on Tuesday. The index has plunged 11.6% in February so far, after soaring 16% in January. The Philadelphia Oil Service Index fell even more after cautious comments from

Transocean

(RIG) - Get Report

, losing 2.76% Tuesday, adding up to a 12.2% loss for February so far.

Big declines were evident in

Valero Energy

(VLO) - Get Report

,

Sunoco

(SUN) - Get Report

and

Amerada Hess

(AHC) - Get Report

.

Conversely, transportation stocks such as

Jet Blue

(JBLU) - Get Report

and

Continental Airlines

(CAL) - Get Report

benefited from crude's weakness, as did economic cyclical names such as

Caterpillar

(CAT) - Get Report

and

Alcoa

(AA) - Get Report

.

Losing Energy

Given that energy has been the leading growth sector of the market for quite a while, the question becomes, is this pullback providing a buying opportunity?

Not so, according to Bernie Schaeffer, the head of Schaeffer's Research in Cincinnati. In fact, he doesn't like all the bullishness still felt for the sector on Wall Street.

Unlike the stocks of gold-mining companies, which have some of the lowest buy ratings from analysts of any sector tracked by Schaeffer, Wall Street remains very much enamored with the energy sector. Oil service stocks enjoy a collective buy rating of 73% and oil stocks have about 61%, according to the research firm.

"There is therefore precious little upgrade fuel in the tank to keep these stocks rallying," Schaeffer wrote.

There are other reasons to be bearish on the energy sector. Besides easing worries about Iran's supply, a mild winter has also allowed inventories of heating oil and distillate to build, while gasoline inventories have risen amid higher refinery utilization, according to Jason Schenker, energy analyst and economist at Wachovia.

In fact, he says the price of petroleum products have been falling faster than the price of crude, which means that the profitability refiners can draw from selling their product has turned negative this year.

"Since the profitability of refining gasoline is technically negative, refiners are likely to reduce production," Schenker wrote. "This should sap crude oil demand, making crude oil prices fall

further."

The decline could be stemmed if the Organization of Petroleum Exporting Countries (OPEC) cuts production in March and/or if geopolitical tensions resurface, he says. "Without an OPEC production cut or major geopolitical disruption event, however, crude oil prices could test $50 per barrel this spring."

On the face of it, there might not be much to cry about if energy prices do indeed continue to correct, relieving pressure both on consumers and on corporate bottom lines.

But the problem with the energy sector is that it has accounted for much of the earnings growth and market gains seen for most of 2005 and through January of 2006.

As reported

here, earnings growth of 14.6% in the fourth quarter falls to 9% if one removes energy's contribution, according to Thomson Financial. Estimates that earnings will grow 10.8% in the first quarter turn to 6.2% excluding energy. That means energy earnings make up 38% of the growth in the fourth quarter and 43% in the first quarter.

Depending on how quickly profit expectations for the energy sector start declining, Wall Street may soon lose the promise of "double-digit" earnings growth, which has been one of its main selling pitch to attract (unsuccessfully) retail investors.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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