As the end of the year approaches, various firms are putting out their stock recommendations for the year ahead. The Energy sector has gotten killed this year, dragging so heavily on earnings in the S&P 500 that the index posted its first earnings decline in years during the third quarter. The sector has also underperformed Consumer Discretionary over the last seven years by over 260%.

Energy Sector

Nevertheless, there’s a light at the end of the tunnel, according to JPMorgan analysts, who upgraded the Energy sector to Overweight this week. They say speculative positioning in the sector is “already extremely short,” and they expect the technicals to reverse soon, providing a “significant lift for all assets tied to the energy complex,” they wrote in their “U.S. Equity Strategy” report dated Dec. 9.

Momentum trades riding on several factors

Analysts Dubravko Lakos-Bujas, Bhupinder Singh and Scott Linstone noted that several factors have resulted in significant momentum and macro crowding, which is why they think a change in market leadership is forthcoming. Among the macro trends that have contributed to the recent years-long momentum are divergences in central bank policies, the strengthening U.S. dollar, tumbling commodities prices and emerging market assets, and falling bond yields.

Energy Sector

Energy Sector

Energy Sector

The JPMorgan team notes that these factors have carried momentum across global markets and multiple asset classes, for several years in some cases. In the meantime, however, momentum in the Energy market is negative, and the last time it remained negative for as long as it has been negative right now was in 1998.

Energy Sector

Further, most of these equity trends depend on what the U.S. Federal Reserve does. Regulators are expected to raise interest rates this month, and it’s expected that the U.S. dollar would receive another boost and commodities prices will weaken even further.

However, they say that there’s risk that the equity trends that depend on what the central bank does don’t materialize, leaving some trades too crowded and prone to sharp reversals like the euro to U.S. dollar move after the European Central Bank made its decision. They add that 13F filings suggest that investors who are long-only are still underweight on Energy, although they are “less negative sequentially.”

Why upgrade Energy?

The JPMorgan team said they upgraded the Energy sector to Overweight because they expect it to become a “relative outperformer” by the end of next year. They expect oil prices to recover as non-OPEC supply shrinks and demand strengthens in the second half of the year. This should in tern improve earnings visibility and support the new technical picture. The analysts add that it’s difficult to pinpoint the exact timing of this shift in the Energy sector but that the recommend that investors buy on dips and begin “rotating into Energy from expensive, crowded and macro-driven Momentum sectors” like Consumer Discretionary.

Volatility in the Energy sector is expected to continue during the first half of 2016, so they think it’s best to start by focusing on “higher quality stocks with superior asset mix, stronger balance sheets, and exposure to the lower end of the cost curve.” Among the Energy stocks they recommend first are Chevron, Halliburton, Schlumberger, Sunoco, and Occidental Petroleum.

Moving into the third phase

Because the Energy sector is capital intensive, the JPMorgan team said it follows three main phases: easy financing, which involves new drilling and extra production; debt covenant violations and credit term renegotiations due to lower prices; and an increase in consolidation of defaults and industry. The analysts expect the third phase to play out into the second half of next year and then for the Energy sector’s fundamentals to begin improving.

They note that their recommendation of the Energy sector is “clearly a contrarian call” as credit spreads remain elevated and a double-digit default rate is expected in 2012. Also speculative short position remains high, and Wall Street just has low ratings on Energy stocks in general. However, they note that the dispersion level in the Energy sector is the highest of all sectors, which means that stock pickers have greater opportunities to differentiate possible winners from losers.

Energy Sector

Private equity firms are attempting to come to the Energy sector’s rescue, suggesting that they too see vast potential in its significant underperformance.

Graphs in this article are courtesy JPMorgan.