Energy stocks are in a bubble — and here’s when they’re likely to crash

Oil and gas stock prices are probably in a bubble that could burst. Applying a model from recent academic research into the predictability of stock market booms and subsequent crashes leads to that result.

Yang You of the University of Hong Kong, Robin Greenwood and Andrei Shleifer of Harvard University, and the study was published in the Journal of Financial Economics.

The probability of a market sector crashing, defined as a 40% decline over two years, was connected with its trailing two-year performance relative to the entire market.

The figure above shows U.S. data from 1926. When an industry or sector beat the market by 100 basis points over two years, there was a 53% chance it would decrease by at least 40% during the next two years. When the trailing two-year outperformance was 1.5%, the probabilities were 80%.

These results make the energy sector vulnerable. The Energy Select Sector SPDR topped the S&P 500 by 153 percentage points in two years. 80% of the energy sector will plummet by 40% or more in the next two years if the past is prologue.

Energy bulls may argue that the sector is in a different place than those assets. The sector's P/E ratios are substantially below the U.S. stock market.

Stronger fundamentals may not safeguard the oil sector from a crash. The Journal of Financial Economics study found little evidence that basic determinants affect crash probability.

In an interview, Harvard's Greenwood stated that he and several other colleagues are still looking for these elements. He does not believe that any will materially lessen the energy sector's current susceptibility to a sharp price decline in the interim.

Energy equities' crash risk doesn't make them good short-sale prospects. Even though these stocks' values will likely be much lower in two years, there's no guarantee they'll fall from current levels.

Contrarily, the researchers discovered that before giving in to gravity, sectors that meet their bubble criteria typically increase by an additional 30% on average.

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