02/08/2011 10:07 am ET | Updated May 25, 2011

Trend Reversals

The extremely undervalued, large cap quality stock universe is finally showing signs of life. Since late November, value stocks have been outperforming growth stocks. And more recently, the Dow has been outperforming the Russell. Large cap stocks have traded at a persistent and growing discount to small cap stocks for about the last seven years. Kevin Lane at FusionIQ points out that they are currently trading at their lowest relative value since 1983. Many people can't even remember the large cap universe's glory days. But extreme valuation disparities usually revert to the mean. The Dow's outperformance of the Russell in the last couple of weeks could be an early signal of another multi-year bull market for large cap names.

Within the large cap universe, one of my favorite sectors is energy. For starters, it is extremely unloved. According to strategy firm Wolfe Trahan, the sell-side expects the energy sector to be the second worst performing one in the S&P in 2011. They looked at an aggregate of sell-side analysts' price targets on Bloomberg, and found that on average, analysts are projecting 12 month returns of 5% for energy vs. about 10% for the overall market. Only the traditionally defensive utilities sector is expected to do worse. Even within the commodity sector, investor sentiment is low on crude and natural gas. Whereas commodities like cattle have over 80% bullish readings, crude oil is around 65% and natural gas is the least loved commodity at 45%. In late January, natural gas posted its highest short interest reading since March 2008. In the 4 months post that high water mark in 2008, natural gas returned over 20%. A similar rebound could happen this year, especially with the extremely cold winter we are experiencing. Aside from these low expectations, natural gas was one of the worst performing commodities of 2010, down over 20%. So from these levels, there is little downside risk.

Taking a more long term perspective, I think that natural gas is very intriguing. Exxon Mobil puts out an annual energy outlook, highlighting what they are focusing on while developing their long term plans. Perhaps their acquisition of XTO Energy made it obvious, but they are clearly bullish on natural gas over the long run. While they expect robust energy demand growth through 2030, they highlight natural gas in particular as a candidate for enormous growth. If you believe their analysis of market dynamics, their natural gas forecasts are not much of a stretch. As the emerging world continues to develop, the need for electricity should grow rapidly. The Exxon report highlights that currently 20% of the world still lacks access to electricity. As non-OECD countries grow their household incomes, Exxon predicts electricity demand will grow 80% through 2030. Their research shows that natural gas currently represents about 20-22% of global electricity production. So with 80% category growth and marginal share gains over coal, natural gas could be poised for 85% demand growth in power generation. This is a massive tailwind, and one that I think some domestic US natural gas producers have picked up on. While the US has traditionally been a net importer of energy, we have experienced a boom in unconventional gas production over the last several years. The pace of exploration and development has been incessant enough to drive down prices for the time being.

However, as emerging economies' demand continues to outpace that of developed markets, enterprising businesses will find a way to get the product to the customer that offers the best price. As noted in a recent Wall Street Journal article, some US companies are talking about building terminals to export natural gas in the form of LNG. Just ten years ago, companies were building LNG terminals to import natural gas. This is a major trend reversal, and one that I think will have legs for years to come.

Rosenau/Paul is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, MSRB and SIPC & HighTower Advisors, LLC, a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC.

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