Bob’s Journal for 3/17/22

The Surge in Energy Stocks

It is hard to believe the numbers on the 2022 rally in energy stocks.

Not long ago, you almost had to pay investors to hold energy stocks. All commodities, including energy commodities, were in long-term bear markets. In addition, governments globally were ramping up their campaigns to encourage businesses and consumers to convert from fossil fuels to other forms of energy.

Trends began to change in 2021, but the change really accelerated in 2022. Even before the Russian invasion of Ukraine, global growth was pushing up the prices of energy commodities and stocks faster than the broad market indexes were increasing.

As of last Friday’s close, in 2022 the Energy Select Sector SPDR (XLE) exchange-traded fund (ETF) was up 39.59%. That’s right. It’s up just under 40% in less than 2½ months.

Meanwhile, the SPDR S&P 500 (SPY) ETF — which tracks the S&P 500 — was down 10.42%.

In the first 50 trading days of 2022, the gap between the two ETFs was about 53 percentage points, according to Bespoke Investment Group. Bespoke reported that since the ETFs began trading in 1999, there has never been a 50-day trading period when XLE exceeded SPY by such a margin.

Part of the reason for the excess performance by energy stocks is their extended and extreme period of underperformance in previous years.

XLE outperformed SPY from 1999 through 2008. But after 2008, XLE stumbled and by 2020 have given up all that previous outperformance. XLE continued to trail SPY through early 2021 before beginning its recent recovery.

In fact, the recent surge only brings XLE’s price back to where it began in 1999, 23 years ago. Following the low point of the financial crisis, SPY generated a return more than five times that of XLE. It’s no wonder energy stocks and commodities have had a correction this week with XLE down 7.38% in the last five trading days.

But the outperformance by XLE is likely to continue after the correction. Energy supplies already were tight before the invasion of Ukraine. The invasion is estimated to take up to 10% of the world’s energy supply off the market. It takes a long time for other producers to ramp up supply, so demand is likely to exceed supply for energy for some time.

Dealing with the Changing World Order

Though the conflict with Russia dominated recent headlines, the leadership challenge from China is the more significant and long-term clash for the United States.

China is stronger than Russia economically and financially and is increasing its military and diplomatic strength. China has made no secret that it intends to replace the United States as the dominant country in the world both economically and politically.

While a change in global leadership is a new experience to us, it’s not unusual historically.

If you want some perspective on the conflict between rising and falling world powers, consider the book by Ray Dalio of Bridgewater Associates “Principles for Dealing with the Changing World Order.”

Dalio looks back at about 500 years of global history and examines other times when the dominant global country was challenged by another country. Dalio documents what he believes are the key characteristics of a dominant country and the changes that typically cause the dominance to end.

As a successful investor, Dalio also addresses how an individual investor should position a portfolio during a possible transition period.

In addition to the book, Dalio has posted on YouTube an animated video he narrates that summarizes the book and can be viewed without charge.

With Markets Down, Consider an IRA Conversion

Instead of fretting about falling markets, consider whether they are an opportunity to convert all or part of a traditional IRA or 401(k) plan to a Roth IRA.

You know that when a traditional IRA is converted to a Roth IRA, there’s a tax to be paid on the conversion. The amount converted must be included in gross income as though it were distributed to you. You pay ordinary income taxes on the amount that’s converted.

When a portfolio declines, you can convert more of it (such as more shares of a stock or mutual fund) for the same tax cost that would have been incurred before the market decline. Or you can convert the same amount of the investment for a lower tax cost.

A conversion that didn’t make sense before the market decline might be attractive to you after the decline. Or a conversion that looked attractive before might be more attractive now.

Most IRA custodians will allow you to convert specific holdings of an IRA. For example, if you have some stocks with lower values, you can transfer those shares to a Roth IRA as a conversion.

If the investments recover, you’ve turned more wealth into tax-free wealth than you could have before.

Keep in mind that the original owner of a Roth IRA doesn’t have required minimum distributions. The wealth you convert stays in the Roth IRA for as long as you want it.

That makes a conversion especially attractive as an estate planning move. You create tax-free wealth for your heirs, and it compounds in the Roth IRA for them to inherit unless you need the money.

Consider a decline in one or more of your investments to be a potential opportunity to convert all or part of a traditional retirement account into a Roth IRA. You could create more future tax-free wealth than you could have a few months ago.

bo