The energy sector is demonstrating strength with a “compelling valuation” that could set stocks up for a comeback after underperforming the broader market since September, according to Morgan Stanley. Strategists led by Michael Wilson upgraded the sector to overweight, anticipating the market rally should broaden and rotate into energy stocks — as long as they can deliver on earnings growth. “We continue to believe we’re in a late cycle market environment, which has historically been supportive of Energy outperformance,” the analyst wrote. Morgan Stanley recommends ConocoPhillips , Devon Energy , Occidental Petroleum and Diamondback Energy as ways to play the potential comeback. The energy sector has been the best performer over the past month, but is still lagging the rally that began in October. Wilson pointed out that energy stocks have actually contributed more to the change in S & P earnings since the pandemic than any another sector. “Yet it remains one of the cheapest and most under-owned areas of the market,” Wilson told clients Monday. The energy sector’s performance has also lagged the price of crude oil this year, but the divergence is likely to close, according to Wilson. The S & P 500 energy sector is up more than 11% in 2024, while West Texas Intermediate futures have gained 14%. The broader S & P 500 has added 9.5% year to date. The increase in crude prices year over year suggests the sector could see earnings growth, Wilson wrote. Earnings revision breadth for energy stocks also appears to have bottomed and is moving in a positive direction, according to Morgan Stanley. The energy sector’s free cash flow margins are down over the past two quarters but are still above the historical run rate, Wilson said. And the sector’s net debt compared to earnings before interest, taxes, depreciation and amortization is below the historical average dating back to 2010.
