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Q1 2020 sector scorecard

A healthy outlook for several sectors as US stock market reaches new all-time highs.

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2020 has seen the US stock market reach new all-time highs, with the Dow Jones within striking distance of 30,000 and the Nasdaq nearing 10,000 for the first time ever. US-China trade talks, earnings results, and central bank actions continue to act as primary market drivers.

If you are looking for new investing ideas, or are reassessing the US stock allocation of your portfolio, this report finds that financials, technology, communication services, health care, and industrials scored more positive than negative marks, based on 3 key factors. Read on to see how the 11 US stock market sectors scored.

Scorecard: Improved growth outlook drives Q4 US stock surge

Stocks rallied in the fourth quarter, helping the equity market post impressive full-year 2019 gains. The information technology (14.4%), health care (14.4%), and financials (10.5%) sectors led the market in Q4, as investors anticipated a pickup in earnings growth. Our sector strategist believes a potential recovery in corporate earnings growth could boost the market—and cyclical stocks in particular—over the coming months.

Fundamentals: Tech, consumer discretionary, health care lead

The technology, health care, and consumer discretionary sectors scored highest on the fundamental factors under consideration. Technology ranked first in earnings-per-share (EPS) growth, and free-cash-flow (FCF) margin, and second in return on equity. Health care also fared well on EPS and EBITDA growth as well as FCF margin. By contrast, fundamentals were relatively weak in the energy, real estate, and utilities sectors.

Relative valuations: Financials and materials look cheap

Financials stocks appeared inexpensive at the end of Q4, as the sector's P/E and P/B ratios were near the lowest ends of their historical ranges. Materials and industrials stocks also looked inexpensive compared to their historical average valuations. By contrast, the valuations of the technology, health care, and real estate sectors appeared elevated.

Relative strength: Technology and financials on top

Strong fourth-quarter performance helped push the technology and financials sectors into the top spots in our relative strength rankings. Communication services stocks also screened well. Shares in the materials, consumer discretionary, and energy sectors trailed the market considerably in Q4, depressing their momentum as 2019 drew to a close.

Bank lending conditions suggest recession is unlikely

Bank lending standards can help gauge the direction of hiring, and by extension the direction of the economy. While lending standards have tightened somewhat recently, they have not reached levels that have historically coincided with contractions in hiring. Some metrics suggest bank willingness to lend is positive, and has historically improved after Fed rate cuts. If history is a guide, 2019 Fed easing could lead to more lending and lower odds of recession.

An on-hold Fed may buoy equities, especially cyclicals

The Federal Reserve has stated that it intends to keep its interest rate policy on hold in 2020. That stance has historically been constructive for the stock market: Since 1983, the S&P 500 has gained an average of 7% during 6-month periods when the Fed has left its benchmark rate unchanged, outpacing its average 6-month return when rates either rose or fell. Cyclical stocks have outperformed the broader market on average during those periods.

A strong outlook for small business earnings

Small businesses have become more positive about future earnings growth. According to the National Federation of Independent Business (NFIB), most small businesses reported declining earnings for most of 2019—but since October, the net percentage reporting higher earnings jumped into the top quartile of periods since 1974. Amid such strong NFIB survey results, total market earnings advanced 93% of the time over the next 6 months and accelerated 58% of the time.

Stocks tend to gain when earnings inflect higher

Rebounding earnings have been meaningful for the market historically. When earnings growth has turned from negative to positive as it has recently, the S&P 500 advanced almost 90% of the time. In fact, accelerations in earnings have been more important for stock performance than the level of earnings growth historically. Past earnings accelerations have led cyclical stocks to outperform, especially when the economy hasn’t experienced a recent contraction.

Manufacturing may be due for a rebound

A global slump in manufacturing has pushed some indicators to contractionary levels: The Industrial Production Index and durable goods orders declined from a year earlier, while the Institute for Supply Management (ISM) New Orders Index was recently below 50 (signaling a contraction). Though it may seem counterintuitive, industrials stocks have tended to outperform the broad market in the 12 months following such conditions.

There may be value in semiconductor stocks

The ISM New Orders Index weakened in recent years and semiconductor valuations fell below levels seen during prior declines in this manufacturing indicator. The industry had begun to rally in 2019 despite the ISM's downward trajectory, contributing to investor caution. But semiconductors have outpaced the market 67% of the time after the ISM fell below 50 when their valuations were this low—only slightly lower odds of outperformance than when the ISM was rising.

Riskier health care stocks may be cheap

In health care, the valuation gap between the most expensive and least expensive stocks is much wider than usual. This dispersion may give investors a chance to find value among out-of-favor stocks. Shares of health care companies that have experienced higher volatility, including managed care firms and facilities operators, are trading at an unusually large discount to the rest of the sector, which may present opportunities for value-focused investors.

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