The resource sector is seeing signs of recovery, with gains in oil and iron ore prices after a sustained rout in the last 20 months, but investment bank Goldman Sachs is still underweight on the segment's stocks, it said in a note on Wednesday.
Goldman has three main reasons that now isn't the time to take bets on resources stocks.
First, prices need to remain lower for longer to drive production cuts and remove oversupply, it said.
Secondly, Goldman expects the U.S. Federal Reserve will surprise the market with three interest rate hikes this year, reversing recent U.S. dollar weakness. A stronger greenback typically weighs on many major commodities, which are denominated in the U.S. dollar.
Additionally, resource stocks now trade at valuations about 20 percent above their long-run multiples, Goldman said.
"It is this last point, the valuation premium, that many investors are typically quickest to dismiss," said analysts Matthew Ross and Bill Zu.
"The common belief is that the market tends to do a good job of picking turning points in the earnings cycle of resource firms—that the time to buy them is actually when they appear expensive, as it's at this point that momentum has turned and analysts will soon be upgrading," they said.
History however suggests that this view is only "half right," they added.
Valuation multiples at these levels have historically been a headwind to outperformance in resources stocks, even though earnings upgrades tend to come at this point, noted Goldman.
In fact, in six out of the eight periods where cash flow multiples have hit levels similar to where the sector is currently trading, the sector has underperformed the market over the following 12 months, Goldman said.
"Further, the post global financial crisis period has seen more significant periods of underperformance when multiples have been elevated," it said.
But Goldman's outlook on the sector's stocks isn't entirely negative. It's turning "less cautious" on the earnings outlook for resource stocks than it had been "for some time."
"Policy makers appear more willing to act to stimulate the Chinese economy, particularly with fixed asset investment. And, at the stock level, the recent decisions to cut dividends by the big miners has removed the tail risk of the firms weakening their balance sheet position by funding unsustainably high dividends," Goldman said.