Investors are overlooking a key sector of the stock market. 3 reasons market pros see big upside in energy

• Investors missed energy stocks' strong potential due to their solid valuation-based fundamentals, experts say.
• The recent rallies in energy stocks are smashing through crucial resistance levels from the 2022–2023 peaks.

Technology seems to get all of the attention in the stock market, but investors should turn to a less glitzy sector that's ripe for strong gains amid a cocktail of bullish tailwinds.

Energy stocks should be getting more attention, market experts say, as the sector has kicked this year off with an impressive streak, with the S&P 500 Energy index delivering returns of 16.3% so far in 2024. However, the top Wall Street economist David Rosenberg said investors aren't yet taking advantage of the sector's favorable position in the market.

"It's an overlooked part of the market, as investor positioning is extremely negative (-$2.7 billion outflows from the SPDR Energy sector ETF over the past year). That's a contrarian positive," Rosenberg told Business Insider in an email on Friday.

Market watchers say there are three big reasons energy stocks are in line for more gains this year, with analysts eyeing as much as 20% upside for the sector from current levels.

Strong fundamentals

Just as tech stocks ride high on robust earnings, LPL Financial flagged in a note energy's stellar earnings revisions that topped all S&P 500 sectors in March, a timely reminder for investors with first-quarter earnings season kicking off.

"Favorable revisions, in concert with higher oil prices, have the sector poised for solid upside to estimates, in our opinion. Better capital allocation decisions by producers should help increase the chances that the sector's earnings are well received by markets, although a strong US dollar may present a bit of a short-term challenge," Jeff Buchbinder and Colby Hesson of LPL Financial wrote in a note this week.

Rosenberg said the recent rise in oil prices could mean better results for refiners and higher sales for exploration and production firms.

"A sustained uptick [in prices] also means more capex in the sector, which translates to investment in storage, transportation, and equipment infrastructure, acting as a tailwind for these sub-sectors within Energy."

With energy players eyeing cash flow for juicier dividends, buybacks, and slashing debt, Buchbinder and Hesson foresee sector valuations rising, in line with Rosenberg's prediction.

"Our Strategizer model's valuation subcomponent for energy is at the 55th percentile on an absolute basis and at the 11th percentile compared to the S&P 500," Rosenberg said.

Technical strength is high

The energy sector rallies are smashing through crucial resistance levels from the 2022–2023 peaks, with Buchbinder and Hesson saying the breakout was confirmed with bullish momentum and widespread buying pressures.

"Over 90% of sector stocks are now trading above their 200-day moving average, while nearly half of the sector registered new 52-week highs earlier this month. Based on the size of the prior consolidation range, a minimum technical-based price objective points to around 20% of further upside from current levels," they wrote.

Adding to the strength is the seasonal prime time — April — as energy consumption typically surges heading toward the summer driving season. With the S&P 500 Energy sector index boasting over 3.7% average returns, and a 70% chance of positive returns based on historical data, Rosenberg said the momentum will extend to May.

"While seasonality remains favorable, we believe it's the great risk/reward profile of the sector that will drive the returns in the months ahead. Our models, which focus on recommendations from a 12-month perspective, recently saw the Energy sector screen as highly attractive. So, we see the momentum continuing," he said.

Macro drivers

As hostilities escalate in the Middle East and the conflict between Russia and Ukraine shows no sign of ending, such geopolitical uncertainties combined with OPEC+'s production cuts will continue to drive up oil demand and prices, LPL said.

Rosenberg agreed that this would be another powerhouse for the energy stocks to go higher, but warned that a growth-related drop in aggregate demand would pose the biggest risk to the sector.

On the monetary policy side, Buchbinder and Hesson noticed the sector's potential protection against sticky inflation and higher-for-longer rates.

They note that energy stands alone as the only sector positively correlated to 10-year Treasury yields, offering investors a potential portfolio hedge against higher rates.