VDE - VDE: It's Not Time To Be Greedy (Downgrade)

2023-09-11 15:49:26 ET

Summary

• Vanguard Energy ETF is a popular way to invest in the energy sector and it has delivered strong gains in the short-term.
• This suggests a more cautious approach could be warranted. The Energy sector's earnings are down year-over-year and this is a disconnect with rising share prices.
• The Energy sector will continue to be a place to be as rising demand is driven by a growing population and middle class around the world. But timing is important.

Main Thesis & Background

The purpose of this article is to evaluate the Vanguard Energy ETF (VDE) as an investment option at its current market price. This is a passively managed sector fund with an objective to "track the performance of a benchmark index that measures the investment return of stocks in the energy sector."

VDE is a very popular sector fund and has long been my preferred way to gain exposure to this area. I typically take a more active approach with most sector ETFs, and VDE is no exception. This leaves me revisiting it more often than others and given that fours have passed since my last article, I thought now was a good time. Lo oking back, I turned bullish o n VDE back in May, and boy was that call a good one!

As you can see, this has offered a return over 2 1/2 times the broader market. Quite a big win.

With this in mind - it is naturally to wonder if more gains could be on the way. After consideration, I do see potential for more gains, but I think out-performance is going to be difficult after such a great short-term run already. This leads me to suggest readers invest in this sector more selectively and carefully under the reality that pullback risk has been elevated. Therefore, I am downgrading my rating to "hold" and will detail the reasons why below.

Bets Are All Turning Bullish - Contrarian Signal

One development that has caught my attention recently is that the move in oil markets is getting overwhelmingly bullish. This has been great for me as an Energy/oil investor and part of me loves to see it. The problem is I tend to want to initiate or build on to these positions when the market is against me. At present, money managers are now the most bullish on US crude in over a year. That means that I am running with the herd - which can work for a while - but often has a way of correcting itself:

What we are seeing from this graphic is that net-long positions in WTI crude have risen substantially in the short-term. In fact, they are at a level not seen since June 2022. Again, this is good for supporting current price gains - but can these gains last? That is the million dollar question.

Without a crystal ball we can never know for sure what the next few months will bring. And it is true that oil has tremendous momentum and plenty of underlying support. So I will absolutely be staying long with most of my position. But we also have to keep in mind this is a volatile asset class - making the Energy sector relatively volatile as well (compared to the S&P 500). If my fifteen years of investment experience has taught me anything, it is that Energy moves up and down on a dime. With such strong gains recently and the market moving aggressively in one direction - my experience also tells me this is not the time to get aggressive, but cautious.

Earnings Headlines A Headwind

My next topic for discussion is earnings. Now - I want to be very upfront on this point in that I do not see overall earnings for this sector as "bad". Quite the contrary, Energy companies on the whole have done quite well over the past year. However, 2022 was a boon year given the spike in oil prices, driven by tight supply and war in Europe. While positive for investors last year, this has made quarterly earnings difficult to beat on a year-over-year comparison. Again, this is not a huge concern for long-term investors, but it does pose a headwind if traders simply look at headlines and don't dig deeper into what the quarterly results really represent.

I see this as relevant because year-over-year results are often what generate headlines because they are easy to understand. Investors want to see "growth", so when results come in that suggest drops in either revenue or profits from the year before, those are often viewed negatively. To put this in to perspective, let us review Q2 earnings reports that have come out over the past few months. While the S&P 500 has seen earnings drop around 5% (YOY), the Energy sector has been a big drag on the overall numbers:

As you can see, the Energy sector has reported a 51% drop in profits in the second quarter. This is due to difficult 2022 comparisons, given how strongly the sector performed. So again, analysts would be wise to take these numbers with a grain of salt because they really aren't "bad" if we consider the whole picture.

But investors and analysts are often emotional and don't actually look at the whole picture. They may just see graphics like the one shown above and be prone to some panic selling or profit taking. This backdrop is why I think it makes sense to get a little more cautious here because Q3 and Q4 earnings are likely to be similar given the 2022 comparisons will be similarly difficult going forward.

Why Stay Long? Dividend Growth One Reason

While there are a couple reasons for concern, I will emphasize I am not a bear at these levels - nowhere near it. I continue to hold on to my positions because I don't want to trigger taxable gains at a time when there is a lack of value elsewhere as well.

In addition, there is an income story to consider. VDE continues to offer a dividend yield that is higher than the S&P 500. There YOY dividend growth is nothing to shrug at either:

Source: Vanguard

This is not the most aggressive dividend growth rate we have seen, but it is notable because it is outpacing inflation. With CPE figures starting to come down recently, this is a story that should remain in place through year end:

What I take away from all this is that Energy funds - such as VDE - are offering a reasonable yield and dividend growth and that should be top of mind for investors in a declining inflationary environment. While equity funds are not really designed for income, my point is that this is a positive attribute for a sector that also has both momentum and future growth opportunities. That is a win-win backdrop for investors.

Valuation Also Merits Buying Or Holding

There is more than just the dividend to consider when buying VDE. The other is valuation - in particular relative valuations for Energy against the rest of the market. The good news is that this was an unloved sector for a long time. But 2022 turned that reality on its head, and 2023 has continued to pique investor interest. At the same time, earnings have been reasonably strong, and that has resulted in VDE - and the broader Energy sector by extension - to trade at very reasonable valuations.

To put it in perspective, readers should note that Energy is trading at a discount to both its longer-term average as well as the rest of the market:

Now, we should manage expectations here. Energy share prices have been rising and this is pushing up valuations. The fact that the rest of the market is seeing valuations get even frothier does not automatically make Energy a "bargain". That is the essence of this review - we still need to be selective with buy-in positions. This is absolutely true with VDE given its almost 20% return since my "buy" call.

However, investors have to put money somewhere. Even if you are long cash, treasuries, or bonds, being too passive is typically not the right move. I am always majority-long equities, and that has served me very well in the past two decades. This is why I would not advocate outright selling. Equities are usually the place to be and Energy is offering a lot of value. While I see merit to being cautious, this backdrop supports keeping a "hold" rating rather than "bearish".

Energy Will Be The Place To Be Long-Term

I will end this review by reiterating the Energy sector means more than just crude oil and its short-term moves. The underlying companies are here to meet the growing energy demands of the globe - not just the US and not just any one demographic. This is a spot to be for the long-term because energy needs and demands are only going to grow going forward.

I know this to be true because the global population keeps on growing. This means more people demanding more energy. And not just growing in poverty - but the middle class is growing. This story should resonate with anyone who lives in or follows the developing world:

The conclusion I draw here that even though I am concerned about short-term price action in the company shares, I have no concerns about future demand and the ability of the energy majors (which dominate VDE's portfolio) to meet this demand. For that reason VDE will be a core hold in my portfolio now and for the foreseeable future - it is just a matter of how much.

Bottom Line

VDE has had a tremendous run since my last look at it and the result has been extremely enjoyable. There could be more gains on the way. With OPEC+ continuing production cuts , supply for crude will remain tight, supporting prices. Further, the fall and winter seasons are almost upon us, which will boost demand for heating oil and natural gas. This dynamic plays right into the hands of VDE.

However, I see reasons to be cautious too. Traders are moving swiftly in one direction - that has my contrarian alarm bells ringing. Further, whenever I see such large gains in a short time period, I usually get cautious. VDE is no exception to this. A 20% pop in under four months is just not the time to start getting greedy and/or doubling down. Rather, it appears more like a time to take some profit and/or stay patient. At least that is what I will be doing and would suggest my followers do as well. Therefore, my downgrade to "hold" at this time makes sense to me.

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