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The S&P TSX Energy Index has been the top performing sector benchmark by a wide margin in 2014. Recent volatility in energy markets, however, has some investors wondering whether it's time to take some profits. A closer look at valuation levels implies that they should.

In assessing whether domestic energy investments are cheap or expensive, the first order of business is to uncover the stock valuation metric with the best record of predicting the future performance of stocks in the sector.

Price to cash flow valuations have provided the most accurate forecast of future sector performance over the past decade. Using monthly data, price to cash flow was about 80 per cent more accurate in predicting future twelve month performance of the energy index than trailing price to earnings ratios.

SOURCE: Scott Barlow/Bloomberg

The chart illustrates the relationship between price to cash flow and index returns. It's inverse, meaning that stock performance declines as price to cash flow rises.

The ten times cash flow multiple is clearly the line in the sand for the S&P/TSX Energy Index. In September 2005 and February 2011, a ten times cash flow multiple began a period of deeply negative performance in the next twelve months, with losses of 5.7 per cent and 23 per cent respectively.

The current cash flow multiple for the energy subindex is 9.1 times, exactly where it was in August of 2008 and getting to the "do not pass go" sell signal. If the historical, inverse trends hold, the forward twelve month return on energy stocks will begin a decline.

Month to date, the S&P/TSX Energy Index has dropped 2.4 per cent, so the forward return line is already moving lower. If today were the last day of July, the next data point on the forward 12 month performance line would be 24.4 per cent, eight per cent lower than the June 30 2013 to June 30 2014 period.

The current 9.1 times cash flow for the index is an average and there are doubtless individual energy stocks that are attractively priced. But in general terms, investors should reduce holdings in energy stocks as the price to cash multiple rises and add to holdings as it improves.

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