Oil prices have dropped by about 40% over the past six months. Not surprisingly, the decline has led to weakness in oil-related stocks. This weakness intensified last week when shares of many energy companies were assigned Black Friday discounts.

Following the big drop, there have been some calls for investors to start buying these stocks. These calls are based on the assumption that oil prices will rebound in the months to come. Having started my finance career in Houston analyzing energy-related companies, I fully realize the potential profits that can be made from taking a contrarian stance. Being greedy when others are fearful does work in the energy sector.  (It also works well in all other sectors too). The challenge is knowing when a discount is a true bargain. A very big secondary challenge is ensuring the longer-term reward is large enough to justify the short-term opportunity cost of a continued drop in the stock price and/or a period of underperformance.

Fortunately, meeting these challenges does not require forecasting where oil prices will be six or 12 months from now. I don’t know where crude prices will be next year and neither does anybody else. A combination of supply, demand and the strength or weakness of the U.S. dollar all influence the price of crude. There are simply too many underlying variables and wildcard events to make a reliable forecast. There are some basic assumptions we can use, however: the global economy remains highly dependent on oil, the amount of oil in the ground is decreasing, it will become more difficult and expensive to extract it in the future and whenever oil stays below certain price levels, various companies have less economic incentive to continue pumping from certain wells.

There is also one other assumption we can use: valuations are mean-reverting. To the extent that valuations have contracted too much, prices on energy-related stocks should rise. This assumption is at the heart of contrarian investing. Contrarian investors look for situations where the prevailing valuation has priced in most of the bad news but little of the potential for upside. Contrarian strategies work because what ultimately matters is how a stock performs after purchase. As an investor, you want to maximize your potential reward relative to the level of risk you are taking.

How do you know if valuations have priced in enough bad news? Look at the relative valuations. Over a period of time, valuations will fluctuate within a range. Valuations below their historical average are attractive (the stock is cheap) while valuations above their historical average are pricey (the stock is expensive). Be sure to do additional research to ensure that nothing has significantly changed to warrant a reduced valuation. Also, look at the absolute valuation. If a stock has traditionally traded at a price-earnings ratio of 100 and now it trades at 50, it is technically cheap on a relative basis but still darn expensive on an absolute basis. You want the stock to be attractively valued both on a relative and on an absolute basis.

The following tables put the current relative valuations of energy-related stocks into perspective. The first table shows the median sector and industry group median price-earnings (P/E) ratios as of the end of November 2014 (last week's closing price) and how they compare to three-, five- and seven-year average medians. The second table shows the median P/E ratios at four different key dates: the end of last month, June 2014 (just before oil started its recent drop), February 2009 (the end of the last bear market) and June 2008 (near the last record high for oil prices).

The data is from our Stock Investor Pro database and screening program. I used the statistical summary report function (click on “Print” under the “File” menu in Stock Investor Pro) to gather the data.

Table 1. Current and Historical Median Price-Earnings Ratios

Sector / Industry Group	Nov 2014		3-Year Avg		5-Year Avg		7-Year Avg
Energy	14.9		17.6		17.0		15.9
Oil & Gas - Integrated	13.2		13.0		14.3		12.5
Oil & Gas - Operations	13.3		15.8		14.3		15.0
Oil Well Services & Equipment	16.8		19.4		18.1		17.9

Table 2. Month-End Median Price-Earnings Ratios

Sector / Industry Group	Nov 2014	Jul 2014	Feb 2009	Jun 2008
Energy	14.9	19.7	6.0	18.6
Oil & Gas - Integrated	13.2	14.2	6.3	11.5
Oil & Gas - Operations	13.3	17.7	6.1	21.7
Oil Well Services & Equipment	16.8	25.0	5.4	17.2

 Source: AAII Stock Investor Pro. Data as of 11/28/2014.

• Selecting a Valuation Method to Determine a Stock’s Worth – A more in-depth discussion of relative valuation and what you should consider when using it.
  
• Making Sense of Master Limited Partnership Rules – Since I’m talking about oil-related stocks and it’s nearing tax time, I thought it would make sense to bring this AAII Journal article to your attention.
  
• How Much Do Commodity Prices Influence Your Investment Decisions? – Tell us on the AAII.com Discussion Boards.
  

Just four S&P 500 companies will report earnings. They are H&R Block (HRB) on Monday, AutoZone (AZO) on Tuesday, Costco Wholesale Corp. (COST) on Wednesday and Adobe Systems (ADBE) on Thursday.

The first economic report of note will be October Job Openings and Labor Turnover Survey (JOLTS) on Tuesday. Thursday will feature November retail sales, November import and export prices and October business inventories. The November Producer Price Index (PPI) and the preliminary University of Michigan’s December consumer sentiment survey will be released on Friday.

Atlanta Federal Reserve president Dennis Lockhart will speak on Monday.

After being at unusually high levels for three out of the past four weeks, the level of optimism among individual investors fell by the largest weekly amount since June 18, 2014 (9.5 percentage points). However, because optimism was at such high levels, bullish sentiment remains above its historical average. Meanwhile, pessimism continues to be below average despite a rebound in bearish sentiment.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 9.5 percentage points to 42.7%. This is a seven-week low. Even with the decline, bullish sentiment remains above 40% for the eighth consecutive week and above its historical average of 39.0% for the 16th out of the past 17 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 4.3 percentage points to 31.4%. The rise puts neutral sentiment above its historical average of 30.5% for the first time in four weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 5.1 percentage points to 25.9%. The level of pessimism registered by our survey was last higher on October 16, 2014 (33.7%). Even with this week’s rise, bearish sentiment remains below its historical average of 30.5% for the seventh consecutive week and the 40th week this year.

Prior to this week’s reading, bullish sentiment had largely been at unusually high levels. Optimism exceeded 50% during three out of the past four weeks. Accompanying the swing back toward the historical average was short-term weakness in large-cap stocks prior to yesterday’s new high for the S&P 500 index.

Keeping individual investors optimistic is the overall upward momentum in stock prices, earnings growth, the Federal Reserve’s ending of its bond purchasing program, falling energy prices and sustained economic expansion. Keeping other AAII members cautious are geopolitical events, a sense that prevailing valuations are too high, the pace of economic growth and worries that a larger drop in stock prices is forthcoming.

This week’s special question asked AAII members whether their six-month outlook for stock prices has been impacted by third-quarter earnings. Nearly 19% said third-quarter earnings gave them reason to stay bullish or become more optimistic. Earnings growth and economic growth were the primary reasons given as to why. An equal number of respondents said third-quarter earnings had no impact on their outlooks. Several of these members said this was because they have a long-term focus. About 27% of respondents said other factors—including global monetary policy, politics and prevailing valuations—matter more.

Here is a sampling of the responses:

• “Earnings are continuing to grow and price-earnings ratios are reasonable; therefore, stocks should have room to grow.”
• “Earnings have been better than I expected, so I think we will continue to see upward movement in the stock market.”
• “Earnings have not affected my outlook. It’s the global economic slowdown that concerns me.”
• “I think longer-term than quarter-to-quarter earnings.”

Bullish: 42.7%, down 9.5 points
Neutral: 31.4%, up 4.3 points
Bearish: 25.9%, up 5.1 points


Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Individual investors’ allocations to equities rebounded for the first time in three months, according to the November AAII Asset Allocation Survey. The rise occurred as both fixed-income and cash allocations declined.

Stock and stock fund allocations rose 3.1 percentage points to 67.2%. This is the largest allocation since August 2014 (67.3%). The increase puts stock and stock fund allocations at or above their historical average of 60% for the 20th consecutive month and the 22nd out of the past 23 months.

Bond and bond fund allocations declined 1.2 percentage points to 16.0%. Fixed-income allocations were last lower in May 2014 (15.5%). Last month was the fourth consecutive month with fixed-income allocations above their historical average of 16%.

Cash allocations declined 1.9 percentage points to 16.8%. November was the 36th consecutive month with cash allocations below their historical average of 24%.

The rise in equity allocations occurred as individual investors were optimistic about the short-term direction of stock prices. Bullish sentiment in our weekly sentiment survey was above 50% during three out of the four weeks measured last month. At the same time, large-cap stocks continued to reach new highs. Plus, many AAII members continue to be frustrated by low bond yields and low interest rates on money market accounts. 

November’s special question asked AAII members how the coming end of the Federal Reserve’s bond-buying program influenced their thoughts about allocating to bonds or bond funds. More than half of all respondents (53%) said the announcement had no impact. An additional 14% said they do not own fixed-income investments or are avoiding them. Approximately 7% said they are not adding to their fixed-income allocations or are reducing their allocations. Roughly 6% said they may either buy bonds or bond funds or are prepared to do so if interest rates rise.

Here is a sampling of the responses:

• “No effect whatsoever. I keep a short five-year ladder of Treasury notes only.”
• “Not much impact. [The bond-buying program] was unlikely to continue too much longer and I think that the market realized that.”
• “Will not invest in bonds. Rising interest rates = lower bond prices.”
• “Expected [the bond-buying program to end] for the last year, so had little effect as I’m already in short- to medium-term funds.”
• “I will continue to stay light in bonds. Returns are just not that terrific.”
• “I may take advantage of buying opportunities in the coming years as prices fall and yields rise as I tend to hold to maturity.”

• Stocks and Stock Funds: 67.2%, up 3.1 percentage points
• Bonds and Bond Funds: 16.0%, down 1.2 percentage points
• Cash: 16.8%, down 1.9 percentage points

• Stocks: 31.7%, up 1.5 percentage points
• Stock Funds: 35.5%, up 1.6 percentage points
• Bonds: 3.5%, down 0.4 percentage points
• Bond Funds: 12.5%, down 0.8 percentage points

Take the Asset Allocation Survey.

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