- 2018 has been positive for a majority of sectors thus far.
- Technology once again received the most positive marks in Fidelity's latest scorecard.
- Reasons for caution include high valuations and weak relative strength for a few sectors.
Even with a couple of down days in late January and early February, the US stock market—which is a little more than a month away from completing its 9th straight full year of gains—has gotten off to another good start in 2018. Passage of tax reform, a brief government shutdown, and the cryptocurrency craze have dominated much of the headlines, yet companies continuing to register strong earnings have been the primary driver pushing stocks to record highs.
Among sectors, Fidelity's latest sector scorecard has a familiar name garnering the most positive marks for the first quarter: technology. Materials also scored well, while fundamentals, valuations, and relative strength were a potential concern for a few sectors.
If you are looking to assess the composition of your portfolio, or you are seeking new opportunities, here are some key sector themes to think about during the second quarter.
Scorecard: Technology continued to lead
The Quarterly Sector Update, including the Sector Scorecard, represents input from 3 discrete Fidelity investment teams—each with unique insights about sector investing—to provide a comprehensive view of the performance potential of the 11 major US stock market sectors over multiple investment horizons. The Sector Scorecard’s proprietary methodology measures the relative attractiveness of each sector as measured by 4 key factors: business cycle, fundamentals, relative valuations, and relative strength.
Q4 marked another strong quarter of a stellar year for stocks. All sectors had positive returns in Q4, led by consumer discretionary. For Q1, the technology sector—which was the top-performing sector in 2017—had 3 positive scorecard indicators. Materials also screened well on the scorecard, based on fundamentals and relative strength. Energy fundamentals turned positive amid a rally in oil prices.
Fundamentals: Technology, materials, energy strong
Technology fundamentals continued to strengthen in Q4, bolstered by solid free-cash-flow margins and EBITDA growth. The materials and energy sectors also scored notably well on earnings growth, while energy's free-cash-flow yield and return on equity remain challenged.
Relative valuations: Real estate, utilities appear inexpensive
Based on our framework, real estate, utilities, and telecom currently have the lowest relative valuations, based largely on their compellingly low price-to-earnings (P/E) ratios. Due to recent outperformance, industrials and technology are edging toward the high end of their 10-year ranges.
Relative strength: Technology, financials, materials on top
Technology continued to lead the pack in the fourth quarter, and finished the year as the top-performing sector. Financials also had impressive performance in Q4, sustaining its sharp rally that began in August. In contrast, the consumer staples, telecom, and real estate sectors lagged during the second half of 2017.
We may be in the early stage of an extended profit recovery
In 2017, global markets emerged from a fairly significant decline in corporate profits. Global earnings—especially in US dollars—have since rallied sharply. Accelerating profits tend to benefit cyclical sectors, and we may still be in the early innings—given that the average US profit recovery has lasted approximately 4 years. Signals such as ample bank credit and a recent US-dollar depreciation suggest this recovery may be extended.
A sustained profit recovery should lift wages
If the profit recovery continues on its current trajectory—as many indicators suggest—wage growth is likely to pick up. When profit growth has accelerated and been above 10% historically, wage growth has often followed suit. Although higher wages add to corporate cost bases, wage acceleration hasn't historically hurt profit margins. Sales often accelerate in tandem with or even faster than wages, and profit margins have tended to expand as a result.
A flattening yield curve isn't necessarily grim for stocks
Over the past year, the bond yield curve has been positive but flattening (short-term yields remained lower than long-term yields, but the differential has narrowed). Many investors have become concerned about what this could mean for stocks. But a positive and flattening yield curve has historically been constructive for the stock market. In contrast, an inverted yield curve (when short-term yields exceed long-term yields) has been a headwind for stocks.
Sector leadership has become more sustainable over time
Technology stocks led the market in 2017. The likelihood that a prior year's top sector will continue to outperform in the subsequent year has been mixed, historically. But sector leadership has become more sustainable over time, as economic cycles have lengthened and leadership sustainability has been tied to recession risk. Top performing sectors are also unlikely to rank in the bottom 3 based on performance in the subsequent year.
At elevated valuations, earnings growth is important for financials
The financials sector's relative forward P/E valuation is just above its long-term average. But elevated valuations alone have not caused the sector to underperform historically. When valuations have been near these levels in the past, whether earnings growth has been accelerating or slowing has often meant the difference between financials outperforming or underperforming.
Constructive signals for loan growth supportive of financials
Corporate profits are often a leading indicator for loan growth—an important driver of financials earnings. Recent weakness in loan growth was due at least in part to the 2016 profit contraction. The sharp profit recovery in 2017 will likely lead to a pickup in loan growth, which should be constructive for financials. Capital markets and banks stocks, in particular, have benefited from strong loan growth amid rising interest rates and positive stock returns.
Sustained strong investment spending may boost industrials
Corporate investment spending is often ignited by corporate profit recoveries. A lower corporate tax rate has also tended to support investment spending growth. Moreover, comparing current trends with historical patterns, the acceleration in investment spending that began at the end of 2016 appears poised to continue, which could benefit industrials stocks.
Despite higher valuations, industrials still appear attractive
Industrials relative forward P/E ratios are at the high end of their historical range; however, this has typically not led to underperformance for the sector, largely because earnings growth tends to accelerate. Within the industrials sector, high-dividend-yielding stocks have had consistent performance through economic cycles, highlighting potential opportunities within the aerospace and machinery and defense industries.
Small cap stocks appear well-positioned for gains
Tax reform has historically benefited small cap stocks because smaller companies are often more domestically focused. Small cap valuations relative to large caps also appear constructive. Small caps are generally more expensive than large caps, but when the differential between their FCF yields has been this narrow historically, small caps have outperformed. Thus, sector exposure that includes small caps may be a sensible approach.