Rally in oil stocks means it's time to rebalance

You only have to drive past a gas station to know that crude oil prices are near two-year highs. That's not a pleasant thing for the cost of your daily commute, but it has propped up the portfolio of anyone who bought energy stocks six months ago.

You only have to drive past a gas station to know that crude oil prices are near two-year highs. That's not a pleasant thing for the cost of your daily commute, but it has propped up the portfolio of anyone who bought energy stocks six months ago.

It's a tempting thought: Why not buy the stocks of companies that are profiting from $100-a-barrel oil? Energy companies in the Standard & Poor's 500 are up nearly 10 percent for the year, almost double the performance of the next best performer among the 10 groups that make up the index. But the more energy prices rise — and the more that energy stocks follow — the greater the chance of an economic slowdown that can squelch a market rally.

Just ask Gary Bradshaw. A Dallas-based fund manager with Hodges Mutual Funds, a company with $415 million in assets under management, Bradshaw added to his holdings of Exxon Mobil in August when the stock was trading around $60 per share. It's since shot up to $82. But Bradshaw isn't as happy as you would expect for someone with a 35 percent gain in six months.

"My problem is that if oil goes too high it will kill the economic recovery and send us back into a recession," he says. "High oil prices are good for Exxon, but the truth of the matter is that if they go too high it will kill demand."

The ideal oil prices for a strong stock market are around $75 to $80 a barrel, he says. For now, he is considering the sale of some of his holdings in Chevron and ConocoPhillips if oil reaches $125 a barrel. At that level, he says, consumers will stop shopping, spending money at restaurants or buying new vehicles because the money they are spending on gasoline will make them cost-conscious.

With average gas prices up 35 cents a gallon since an uprising in Libya began in mid-February, "it's too late to be buying energy companies now," Bradshaw says. Exxon, for instance, is trading at 13.2 times its earnings over the past 12 months. That wouldn't be high for a technology stock with a lot of expected growth, but it is higher than average for a staid oil company like Exxon. The company has cost an average of 11.8 times earnings over the past five years.

Energy companies are a good buy if you expect to hold them for three years or more, says John Canally, a market strategist at LPL Financial. But the jump in prices has pushed his team to lower their recommended holdings for stocks in general. "Higher energy prices can mean higher inflation," he says. He recommends buying commodities like silver as a hedge.

Oil companies may be a good buy for the long run. Exxon, for instance, pays a dividend of 2.1 percent, which is more than you'd get from a five-year Treasury note. The company's record of increasing its dividend each year is one reason why Exxon has outperformed the broad stock market over the past 10 years by an enormous margin. An investor who bought Exxon 10 years ago and reinvested his dividends had a total return of 139 percent since then. An investor in a low-cost S&P 500 index fund, meanwhile, had at best a 27 percent total return after fees.

But investors who see those returns and decide to increase the energy portion of their portfolios should consider doing so slowly. "Oil companies have a very bright future because demand is rising from emerging markets," says Quincy Krosby, chief market strategist at Prudential Financial. She recommends waiting for prices to dip or buying at regular intervals, a technique known as dollar-cost averaging.

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