Oil Prices Are Back Above $100. History Says the Biggest Stock Market Loser May Now Offer the Biggest Upside.

Oil prices have spent most of the past month hovering above $100 a barrel. The big driver, of course, has been the Iran war, which has sent crude, gas, and diesel prices soaring.

For equity investors, the obvious trade might be to buy energy stocks, which often benefit from higher oil prices. Energy is the best-performing S&P 500 (SNPINDEX: ^GSPC) sector year-to-date with a gain of more than 50%.

But that might be the wrong strategy. Unless oil prices continue to rise, future upside for energy stocks may be limited. History suggests that the better investment might be the sector that has suffered the most.

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The relationship between energy stocks and oil prices

While it's true that energy stock prices tend to rise as oil prices rise, the potential for returns isn't unlimited. Just because oil prices stay above $100 for a while doesn't mean that energy stocks will keep rising indefinitely.

Take, for instance, the relationship between an energy ETF and an oil ETF: State Street Energy Select Sector SPDR ETF (NYSEMKT: XLE) and the United States Brent Oil Fund (NYSEMKT: BNO). It's not a perfect 1:1 correlation, but you can clearly see that when one rises, the other does as well, and vice versa.

Data by YCharts.

If these two ETFs are highly correlated, that means energy stock prices are likely to stagnate if oil prices start to level out. These companies will likely continue to benefit the longer than oil remains above $100. But it's also reasonable to assume that there's not much short-term upside left unless oil prices keep rising here.

That's a big reason I'm less bullish about energy stocks right now.

The Iran war could send energy stocks sharply lower

With annualized inflation at 3.7% in September and consumers still under pressure from an affordability crisis, oil prices aren't rising due to higher demand. They're rising due to supply concerns related to the conflict in Iran.

When the war is eventually resolved, and the global oil supply chain returns to normal, there's a very good chance that oil prices will fall and inflation will slow considerably. As we see from the chart above, falling oil prices probably mean a potentially sharp correction in the share price of the State Street Energy Select Sector SPDR ETF.

If you believe that the next big move for oil prices is lower and not higher, as I do, energy stocks could be a laggard over the next six to 12 months.

Instead, I'd look at one of the sectors that has been a miserable performer this year, largely due to high inflation: consumer discretionary.

Consumer discretionary stocks become an opportunity

The State Street Consumer Discretionary Select Sector SPDR ETF (NYSEMKT: XLY) is the worst sector performer this year, with a 7% loss and trailing the S&P 500 by roughly 20 percentage points.

While personal spending has remained relatively durable throughout the current affordability problem, consumer sentiment remains near all-time lows. This is still one of the worst eras for home affordability, and the price of everything from gas to groceries to clothing is pushing consumers to the brink.

The performance of consumer discretionary stocks reflects this. But there is some long-term opportunity here if you're willing to swim upstream, buy low, and allow enough time for the narrative to play out.

If the Iran war eventually comes to an end, it should lower inflation rates but, more importantly, increase optimism that better times could be ahead.

Take, for instance, what happened in 2022 and 2023.

In 2022, Brent crude oil prices rose by 35% while the State Street Consumer Discretionary Select Sector SPDR ETF fell by 36%. Soaring inflation damaged all sectors of the economy, but especially those that were more growth-oriented and rate-sensitive.

But in 2023, inflation began to cool, and optimism started to return. Brent crude oil prices finished a volatile year down about 3%, but the consumer discretionary sector gained around 40%.

This isn't a prediction that the same thing will play out over the next year, but there is a recent precedent. XLY may not be a popular pick given what's working in the market right now, but it could provide one of the better long-term opportunities for outperformance.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.