These Stocks Hold the Key to the Market's Returns in 2021

The stock market pushed further into record territory on Friday, closing a remarkable week. There are plenty of uncertainties in the market right now, but investors are nevertheless convinced that everything will turn out well. Market participants are generally dismissing downbeat news about items like low levels of job creation and record-high COVID-19 case counts, instead figuring that coronavirus vaccines will eventually bring the pandemic under control and spur a new wave of expansion.

With optimism reaching exuberant levels, the question is whether the stock market can keep up the pace in 2021. To answer that, you have to look at one particular set of stocks. They don't make up a huge part of the market, but how they fare could make or break 2021 as a winning or losing year.

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How the stock market fared Friday

Major market benchmarks closed at record territory, with the Dow Jones Industrial Average (^DJI 0.50%) joining the S&P 500 (^GSPC -0.15%) and Nasdaq Composite (^IXIC -0.71%) at new highs. Gains for all three indexes were relatively consistent with each other.

Data source: Yahoo! Finance.

The answer is energy

Energy stocks have been off most investors' radars for a long time. That's with good reason: Energy stocks as a group are off more than 30% for the year, compared to the S&P 500's overall returns of more than 15%.

The challenges that the oil and gas industry face stem from two sources. Even before the COVID-19 pandemic struck, supply and demand factors were out of balance in the energy sector, in large part because of advances in recovery technology from shale oil plays and other unconventional assets. Then, when the pandemic hit, the bottom fell out of the crude oil market, briefly sending prices negative as demand evaporated overnight.

Yet in ignoring energy, many investors have missed out on a huge recovery. As recently as early November, energy stocks were down 50% for the year. Yet in just the past month, they've jumped nearly 40%.

Energy stocks played a key role in Friday's stock market gains. Oil prices pushed above $46 per barrel, slowly but steadily making progress in recovering toward more sustainable levels. As a consequence, many of the top-performing large-cap stocks came from energy:

• ConocoPhillips (COP 1.80%) picked up more than 7%, while EOG Resources (EOG 1.59%) was higher by 10% and Canadian Natural Resources (CNQ 0.69%) posted a 5% gain.
• Among refiners, Phillips 66 (PSX 2.02%) gained 7%, with Valero Energy (VLO 1.61%) close behind with a 6% rise.
• The oilfield services sector also did well, with Schlumberger (SLB -2.02%) and Baker Hughes (BKR 1.51%) gaining 6% to 7% on the day.

Energy's performance signals that investors are turning back to the sector. That's welcome news, even though the size of the energy sector has shrunk considerably compared to the rest of the stock market in recent years.

Why energy matters

Energy stocks make up a small portion of the overall market, so it might seem like their performance shouldn't matter. But as a cyclical component of the economy, energy drives a lot of activity not just within the sector but also in related areas like industrials and materials. A cyclical uptick would finally bring many of the laggards of the bull market since March along for the ride, broadening the rally and making it more sustainable.

By contrast, another hit to energy would be a massive blow to confidence in the economy. Technology stocks have done a good job of carrying more than their fair share of the burden of keeping the economy going, but the tech sector can't do everything on its own. 2021's stock market gains will rely in part on other sectors doing their part.

Even as most investors pay close attention to the latest high-tech upstarts, you should keep an eye on energy stocks. They're quietly producing nice returns for those who bet on a quick turnaround, and there could be a lot more momentum going forward.