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Sector rankings: A mixed bag

Breaking with trend, there are no clear-cut leaders in our latest scorecard.

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Despite lingering trade frictions and an uncertain monetary policy outlook, several global stock markets are trading near all-time record highs—including the US. Paradigms continue to evolve at the sector level, including shifts in consumer trends and heightening scrutiny for some communication and technology companies.

If you are looking for new investing ideas, or are reassessing the US stock allocation of your portfolio, this report finds that materials, consumer staples, and industrials were the only 3 sectors with more positive than negative marks, based on 4 key factors. Read on to see how the 11 US stock market sectors scored.

Scorecard: All sectors but energy gained in Q2

Expectations for lower interest rates drove stocks higher in Q2. Cyclical sectors benefited most, with financials, materials, technology, and consumer discretionary leading the market. Our sector strategist is bullish on more economically sensitive sectors, including consumer discretionary, financials, industrials, tech, and materials, which have lower valuations relative to the broad market than defensive sectors and could benefit from Fed actions.

Fundamentals: Tech leads the way

Technology stocks produced strong fundamental results over the past 12 months, leading the market in EPS growth and free-cash-flow margin. Communication services and consumer discretionary also fared relatively well on fundamental measures. The utilities, real estate, and financials sectors produced the weakest fundamental results over the period.

Relative valuations: Financials, materials appear inexpensive

Financials and materials had the lowest valuations (i.e., most attractive) at the end of the second quarter, based on the sectors' historical ranges. Energy also screened inexpensive based on its most recent 10-year range, but remains expensive based on longer-term averages. The technology, communication services, and consumer discretionary sectors appeared expensive due to their strong recent performance.

Relative strength: Cyclical sectors top the market

The technology, consumer discretionary, and industrials sectors led the market on a year-to-date basis, in a reversal of the defensive sector leadership of late 2018. The health care, energy, and materials sectors have lagged the broader market over the past six months.

The equity risk premium may be bullish

The S&P 500's average P/E ratio (a valuation metric of price to 12-month trailing earnings per share) rose from 14.5 to 16.5 in the first half of 2019. But P/E historically hasn't helped predict performance over the next 12 months. Stocks advanced three-quarters of the time from high, low, and in-between P/Es. The equity risk premium—the ratio of stocks' earnings to their price, minus the 10-year Treasury yield—has been a better predictor and is in the cheapest quartile of its historical range, which may be a bullish signal.

Weak trade doesn't necessarily mean a weak market

Many investors are concerned about global trade and may be surprised to learn that the US stock market has been strongest during the 12-month periods when trade growth has been weakest. That negative correlation also holds over longer periods. Why? The market may have priced in slower trade growth prior to these periods, and domestic stimulus may have helped offset its impact.

Cyclical sectors look cheaper than defensives

Defensive sector valuations are historically elevated relative to the broader market, while higher-volatility stocks are trading at their largest discount since the financial crisis (higher earnings yield implies a cheaper valuation). Higher-volatility stocks are in the top quartile as measured by beta. What’s more, the earnings yield of more-volatile stocks is unusually high compared with the yield difference (spread) between high-yield bonds and Treasuries. A narrow yield spread has historically been a bullish signal for stocks.

The high cost of utilities

Among defensive sectors, utilities stocks appear particularly expensive based on both their trailing and projected price-to-earnings ratios. Historically, from these valuation levels the sector has only outperformed the market about 20% of the time over the next 12 months.

How does a rate cut affect the outlook?

Historically, the first rate cut in a Federal Reserve easing cycle has been bullish for the next 6 months. In the 12 months after an initial rate cut, results often depended on whether the economy fell into recession. When it did, the market advanced half the time, with an average return of 7% and leadership by defensive sectors. When it didn't, the market posted strong gains and defensive sectors on average underperformed.

Does the inverted yield curve mean a recession is near?

On its own, an inverted yield curve—when short-term bonds pay higher yields than longer-term bonds—doesn't necessarily signal recession. The Fed continued to raise short-term rates after inversions in 2000 and 2005, prior to the last two recessions. Although the credit crisis overwhelmed the US economy in 2008, higher borrowing costs and commodity prices were also shocks to consumer income—key variables that have historically led to recessions.

Could tariffs trigger recession?

Borrowing costs and commodity prices remain relatively muted and supportive of consumer spending. Tariffs placed on Chinese imports have been passed on to the US consumer, but so far have had significantly less of an impact than prior shocks to consumer income that have helped tip the US economy into recession.

Weak global manufacturing appears priced into financials

The outlook for global manufacturing tends to affect the relative performance of financials stocks. In the last year the outlook has deteriorated, as measured by the global purchasing managers index (PMI), depressing the sector's valuations. Historically, financials stocks have had strong odds of beating the market when trading at low price-to-earnings (P/E) ratios following a global PMI downturn.

Conditions are converging for homebuilders

The consumer discretionary sector tends to outperform when the market avoids recession following an initial rate cut. Within consumer discretionary, homebuilding stocks may stand to benefit now that lower rates are improving home-buying conditions. In addition, homebuilders' valuations are in the lowest decile of their historical range, and the industry historically has had high odds of outperforming the market from these levels.

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