Is It Time to Overweight Energy Stocks?

A reader writes in, asking:

“What do you think of an Energy Mutual Fund such as Vanguard’s Energy Fund for a 3-5% position within one’s stock portfolio at this time?

Some investors such as Buffet have suggested that the time to invest in markets when there is “blood in the streets”, and there is crying from obvious pain.  Do you think the rapid price decline of oil and related energy stocks is a good investment through an energy fund, or should one be satisfied with the percentage of energy and related stocks through an S&P 500 fund or total market index fund?  Is there enough pain and blood in this sector to warrant at least a look at an energy fund for a longer term hold of at least one to three years?”

As of 12/12/14, the Vanguard Energy Fund is down just over 30% from the peak it reached in June of this year.

For an investor considering a temporary overweighting of this industry (relative, that is, to the portion of the overall market that it makes up), the question that must be answered is whether this 30% decline is an overreaction, an appropriate reaction, or an underreaction to the decline in oil prices. It would only make sense to overweight this industry if you were convinced that the recent price decline is an overreaction to the news (i.e., share prices have gone down more than they really should have, making today an opportunity to buy at bargain prices).

So, how would you determine whether the price change is an overreaction?

In short, you’d have to do some math (and a lot of research).

Specifically, you’d have to calculate your expectation for the industry’s future earnings given the new lower oil price (which would necessitate, among other things, an estimate of how long the price of oil will stay where it now is). And then you’d have to calculate what you consider to be a fair value of the industry, given those new earnings expectations.

As for me personally, such calculations and estimates would be well beyond the sort of thing I could do with any significant degree of confidence.

But if you don’t actually take the time to do the research and math, all you’re really doing is guessing.

You could make the case that, yes, it’s a guess, but if you make many guesses of this nature over the course of your investing career, you’ll be right more often than not given that investors tend to overreact to news. But there are, in my view, at least three compelling points against such a strategy:

• Monitoring the news and moving in and out of various funds is quite a bit of work, relative to a simple buy-hold-and-rebalance strategy,
• It involves higher costs, due to transaction costs and/or owning funds with higher costs than broad-market index funds, and
• There’s evidence of a “momentum effect” in most equity markets, which might suggest that investors actually tend to underreact to news at first.