Can Canada’s Energy Sector Continue to Drive the TSX Higher in 2021?

Is it time to consider recovery stocks such part of the energy sector instead of high-flying growth stocks right now?

Oil pumps against sunset

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The COVID-19 pandemic sent the stock market spiraling downward at the start of 2020. Equity indexes, including the TSX, lost over 35% in just over a month, as governments imposed economic lockdowns and shut their borders. The capital-intensive energy sector was among the worst hit, as demand for fuel dropped significantly.

As federal governments pumped billions of dollars into the economy and supported individuals and businesses, the stock market began its recovery. In the last 18 months, investors have witnessed a snap-back rally that has been unprecedented if we consider historical trends. While the recovery in the second half of last year was driven by COVID-19-proof companies that are part of the technology and consumer staples sector, the previous 12 months have seen an uptick in energy stocks.

Can the momentum continue as we inch closer to 2021?

The TSX index is up 32% year to date

The TSX has surged over 32% in the first eight months of 2021. However, the Canadian energy sector has gained close to 67% in this period, easily surpassing their counterparts south of the border.

While several energy companies had to cut dividend payouts to offset high-interest payments and negative profit margins amid COVID-19, the rising prices of oil have supported a stellar turnaround in 2021.

Despite recent gains, the energy sector is still down 8% compared to the start of 2020. Alternatively, the TSX has returned 29.3% in this period. We can see that companies that are part of the energy space have enough room to move upwards given their still depressed valuations and rising oil prices.

The vaccination rollout in several developed countries has gained pace since March, which has allowed governments to reopen economic activities. But international travel numbers remain subdued, and this scenario might change over the near term, as individuals consider non-essential travel once again. Further, offices might consider reopening soon, and these factors should drive oil demand and prices higher.

Is the technology sector overvalued?

While recovery stocks seem attractive, there is a good chance for high-growth tech stocks to experience weakness, given their steep valuations. The Canadian tech ETF has more than doubled since the start of 2020 due to the stellar gains of companies like Shopify, Constellation Software, and Lightspeed POS.

Shopify is valued at a forward price-to-sales multiple of 31.2, which is extremely frothy. Comparatively, tech stocks such as Lightspeed, Docebo and Nuvei are valued at price-to-sales multiples of 32.25, 20, and 23, respectively. These stocks might grossly underperform the broader market if the tide turns.

Pot stocks such as Aurora Cannabis will remain volatile

The Canadian cannabis sector has also remained under the pump for more than two years due to a variety of reasons. Even prior to COVID-19, investors were worried about the valuation of pot stocks that were not in sync with their fundamentals. Companies such as Aurora Cannabis, HEXO, and Sundial Growers are currently trading over 90% below their record highs.

The rising competition in this space coupled with negative profit margins should weigh heavily on marijuana stocks in the next 12 months.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Aditya Raghunath has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Constellation Software, Docebo Inc., Lightspeed POS Inc., and Shopify. The Motley Fool recommends HEXO Corp. and recommends the following options: long January 2023 $1,140 calls on Shopify and short January 2023 $1,160 calls on Shopify.

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