It doesn’t seem like it’s been that long, but I started investing in the stock market more than 30 years ago. In those 30+ years, I have seen my fair share of bear and bull markets. I was a novice investor during the Stock Market Crash of 1987 when the Dow lost 22.6% of its value in a single day. It was an early lesson about the speed at which the markets can change. At a more basic level, it was a lesson in how quickly market perceptions can change.

Perceptions determine value, and sometimes misperceptions cause share prices to become utterly disconnected from underlying fundamentals.

I watched the dot-com bubble that started in 1997 turn average investors into “gurus.” I saw pundits attempt to justify the lofty valuations on many technology stocks. But the underlying fundamentals weren’t there to support these valuations. Once the bubble collapsed, many gurus were exposed as amateurs who had bought into the hype and were riding that bubble. 

How does this all relate to current action in the energy sector? I can recall a few years ago, during the nearly six-year bull market in energy that began in 2009, that it seemed that bearish news never had a lasting impact on the markets. I watched as new oil production came online, and production outstripped demand. Many times I thought to myself “Now that’s got to cause oil prices to fall.”

But oil prices just kept going up, and over time became disconnected from the fundamentals. The price of oil remained at $100/bbl far longer than it should have. It was evident in 2013 that we were headed into a period of oversupply, but the bulls remained in control of the market until mid-2014. One of my January 2014 predictions was that oil prices had to fall, and The Energy Strategist lightened up on some of our more aggressive holdings. Nevertheless, oil prices rose. At mid-year, my prediction for lower oil prices was trending against me, but the fundamentals still suggested a market that was oversupplied.

You know what happened next. Cracks started to appear in the dam, and then it burst. Because the bull market had overextended itself, the correction was swift and deep. 2014 and 2015 were both down years. It looked like 2016 was the beginning of a recovery, with the energy sector bouncing back, but thus far 2017 looks like 2015. The energy sector is down. The sentiment is bearish. All news is viewed through a bearish filter. 

Just consider how the oil market has responded to recent news. There was a pair of unexpectedly large declines in crude oil inventories in the last few months. The market yawned in both cases. Crude oil prices declined. But there has been a pair of large unexpected builds this year, and oil prices were pummeled in both cases. The most recent occurrence happened last week when an unexpected build sent oil prices down by 5%. The good news failed to move the market higher, but the bad news pushed it sharply lower.

Last month OPEC, Russia, and some other significant oil exporters agreed to extend the 1.8 million barrel per day (BPD) production cuts they initiated last November. You would think this would be great news for a market concerned about oversupplies. Five years ago that might have sent oil prices up by 5%, but the market was disappointed that the production cuts weren’t deepened. Crude prices fell by 5%.

The decision by Donald Trump to leave the Paris Accord on climate change was spun by some analysts as bad news for the oil industry. It wasn’t. Nor was the decision by five Arab states to sever ties with Qatar, even though some analysts suggested as much.  

The lesson I learned back in 1987 still applies today. Markets become disconnected from fundamentals, and it can be driven by misperceptions for a long time. The market reaction to recent news suggests to me that we are reaching peak pessimism. After that, hopefully, we can get back to the point that the energy markets are governed by fundamentals for a while.  

I still believe everyone needs some exposure to the energy sector in their portfolio. It’s easy to forget given the sector weakness since the oil price collapse, but the energy sector is one of the top long-term performers among S&P 500 sectors. For now, I will keep making recommendations based on fundamentals, and keep close tabs on supply and demand in preparation for the inevitable reconnection with reality.