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XLE Poised To Outperform S&P

|Includes: Energy Select Sector SPDR ETF (XLE)

Oil Prices at $100.87/bbl for Brent Crude are in the sweet spot for XLE where subsequent returns have been strong and largely positive. Interestingly, Brent prices above $115/bbl are almost exclusively associated with hard negative subsequent returns for XLE.

Oil prices are also down 10% QoQ, this type of selloff in oil has traditionally been very positive for XLE returns in the subsequent three months. If we look at periods over the past three years where Brent Oil fell 10% QoQ and the price of Brent was between $95-105/bbl subsequent 3-month returns are exclusively positive and average 12.14% versus an average of 4.02% over the entire time period. However, all of these observations occurred in the June-July 2012 time frame.

If we graph the Energy Sector versus the Federal Reserve's Balance Sheet, we do not see the extreme over-shots that occurred in mid-2011 and again in mid-2012. It appears the sector has actually begun to price in a flattening in growth of the Fed's Balance Sheet which is consistent with recent Fed verbiage suggesting a slowing in the pace of balance sheet growth.With inflation expectations down 20 bps from 3/18 look for this verbiage to change.

MOMENTUM- If we look at momentum which is in fact an anomaly of "efficient markets", XLE does not have momentum at its back. It has lagged the broader market and most other sectors over the past 3-years. It is also a laggard on a 1-year, ytd, post 12/20/2012 Fed-meeting, 3-month, quarter-to-date, and 1-month basis. It is however a leading sector over the very near-term.

Given this lack of momentum, one would expect XLE to show compelling valuation metrics versus the other major sectors. Below, XLE does appear cheap across a number of traditional valuation metrics. The next question is whether such cheap valuations are a predictor of future excess returns.

Currently, XLE trades 20% cheaper than the S&P on a PE basis. Over the past 3 years, the S&P 500 has outperformed XLE by an average of 0.14% when relative valuation metrics fall within 1 standard deviation of where they are today. Should XLE trade 25% cheaper than the S&P it appears the deck then becomes heavily stacked in XLE's favor. We are not there yet.

With XLE's Price to Book ratio trading 35% cheaper than the S&P's, we are in uncharted water here. XLE has not been this relatively cheap in the past 3 years. XLE has outperformed the S&P by 6.85% on average in the 8 instances where relative valuations are within 1 standard deviation of where they are now. XLE averaged a 15.23% subsequent 3-month return versus just 8.38% for the S&P during these limited instances.

XLE now sports 7% more in dividend yield than the S&P. With the strong demand for yield from investors, this does stack recent subsequent returns in XLE's favor. In the highlighted region below where the relative valuations were within 1 standard deviation of where they stand now, XLE has averaged a 12.62% subsequent 3-month return versus just 6.83% for the S&P outperforming it on average by 5.78%.

With XLE's Price to Cash flow 55% cheaper than the S&P's we are again in unchartered territory. In the 86 observations that are within 1 standard deviation of this level, XLE has returned 8.82% versus 5.78% for the S&P in the subsequent 3 months and averaged an outperformance of 3.04%.

I do own shares in XLE.

Disclosure: I am long XLE.