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The post-recession rotation into cyclical sectors continued in the first quarter of the year with optimistic investors piling into energy, financials, and the industrials sectors. Defensive sectors and tech lagged but showed positive returns. For the future, Fidelity's sector strategist, Denise Chisholm, is bullish on the financials and energy sectors. Find out why and what else to watch for in the second quarter.
Performance summary: Rotation into cyclicals continues
The rotation into cyclical stocks continued into the first quarter of 2021. Cyclical sectors expected to rebound with the economy led by wide margins during the first 3 months of the year, as investors favored them over technology and defensive sectors. Energy, financials, and industrials led the market. Consumer staples, technology, and utilities lagged but still posted positive returns for the quarter.
Scorecard: Bullish on financials and energy
Cheap valuations, relative strength, and the prospect of a continued economic recovery contribute to a constructive outlook for the financials and energy sectors. Conditions may be less favorable for sectors with more defensive characteristics, including utilities and communication services, which have historically been less likely to benefit from economic recovery. Real estate may also face headwinds in the form of high valuations and challenged fundamentals.
Fundamentals: Strength in tech, staples, and health care
As of the end of Q1, the technology sector leads the fundamental rankings, with market-topping positions in EBITDA growth, return on equity, and free-cash-flow margin as well as a second-place finish in EPS growth. Consumer staples and health care also screen well. In contrast, energy ranks last on three of our fundamental measures and second-to-last on the fourth. Real estate and industrials also appear challenged from a fundamental perspective.
As of the end of March, financials stocks have the cheapest valuations for the third quarter in a row. Financials' price-to-book and price-to-earnings ratios rank second and third, respectively, and both are at the very low end of their historical ranges. Energy and consumer staples also look relatively cheap. Consumer discretionary, industrials, and real estate valuations appear the most elevated.
Relative strength: Energy, financials, and industrials on top
The energy, financials, and industrials sectors exhibited the greatest relative strength over the past 6 months, as they benefited from investors' rotation into cyclical stocks. A move away from defensive stocks helped relegate utilities to last place in our relative strength rankings, followed by consumer staples and health care.
US incomes recently hit post-recession highs
The influx of cash from pandemic relief programs has jolted consumer incomes, and this recent rise in real (inflation-adjusted) incomes has been more persistent than at any time since the late 1990s. Income growth, which includes wages, transfers, and stimulus checks, is almost eight times higher than the average 12 months after recessionary troughs since 1960. Although income growth has come off record levels, it clearly remains in the highest quartile of its 50-year range.
Inflation may be on the way, but it may not hurt stock valuations
If history is a guide, top-quartile consumer real income growth may suggest higher inflation—but it may not mean equity valuations will suffer. Starting in 2005, the long-term correlation between income growth and stock valuations flipped from negative to positive. Since then, stock valuations have been more likely to rise than fall when income growth has been in its top historical quartile. Cyclicals fared better than defensives amid high income growth over the same period.
Inflation expectations suggest a market advance
Over the last 20 years, inflation expectations have risen faster than inflation itself about one-third of the time. That's the case now and it may continue as we exit recession. During that span, stocks advanced in 95% of all rolling 12-month periods in which inflation expectations grew faster than inflation. The market's return in those periods was more than three times its return the rest of the time.
Negative real rates may be constructive for stocks
The Federal Reserve has signaled its reluctance to raise interest rates, which could hold down nominal rates across the yield curve. Meanwhile, inflation looks likely to increase. This combination could keep real long-term interest rates negative for some time. Environments with both accelerating inflation and negative real interest rates have been rare. But when they've occurred, the equity market has fared well, advancing in 88% of those episodes.
The inflation breakpoint
Investors worry that rising inflation could boost bond yields and that higher bond yields could weigh on equities. How high would yields have to be to pose a problem for the stock market? Historically, the breakpoint has been a real yield of 2% on the 10-year Treasury. The 2% inflection point has held since 1948 and since the global financial crisis. Real yields are negative now, so they may have room to rise before dragging down equities.
Opportunities in financials
In the past, financials tended to outperform when their fundamentals improved. But that has not been the case since the global financial crisis. The analysis below shows that even if investors had precisely timed when financials' fundamentals would improve, since 2009, the sector would likely still have underperformed over the next year. Rather, financials' periods of outperformance came when their valuations expanded.
Financials' valuations historically have been tied to rates
What drives financials' relative valuation? Historically, it's been the level of interest rates. The steady decline in interest rates from cycle to cycle since 1970 has corresponded with a long downward trend in financials sector valuations relative to the broad market. If inflation leads to higher rates over time, financials stocks' relative valuation multiples may increase, and the sector could outperform.
A sweet spot for financials?
Inflation appears likely to rise above 2%, and inflation expectations could keep increasing. Meanwhile, the economy is emerging from recession. That combination—inflation above 2% and inflation expectations rising—has been the financials sector's sweet spot (outside of the global financial crisis.) Under these circumstances, financials have outpaced the market 81% of the time, outperforming by an average of 3 percentage points.
Financials' run could continue
S&P 500 financials stocks gained approximately 40% in the 6 months through March, outperforming the S&P 500 by more than 20 percentage points. Have investors missed the bounce in financials? Maybe not. When the sector has outperformed over a 6-month period historically, it has continued to do so over the next 6 months more than two-thirds of the time, outside recessions. The sector has had 85% historical odds of outperformance after beating the market by more than 15%.
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Note that the commentary from Fidelity's sector strategist Denise Chisholm begins with the second slide of the presentation, after the performance summary.
Glossary Cycle Hit Rate
Calculates the frequency of a sector outperforming the broader equity market over each business cycle phase since 1962.
Annual dividends per share divided by share price.
Earnings per Share Growth
Measures the growth in reported earnings per share over the specified past time period.
Earnings per share divided by share price. It is the inverse of the price-to-earnings (P/E) ratio.
A measure of a company’s total value that includes its market capitalization as well as short- and long-term debt and cash on its balance sheet.
Free Cash Flow (FCF)
The amount of cash a company has remaining after expenses, debt service, capital expenditures, and dividends. High free cash flow typically suggests stronger company value.
The amount of free cash flow as a percentage of revenue. High FCF margin often denotes strong profitability.
Free cash flow per share divided by share price. A high FCF yield often represents a good investment opportunity, because investors would be paying a reasonable price for healthy cash earnings.
Full-Phase Average Performance
Calculates the (geometric) average performance of a sector in a particular phase of the business cycle and subtracts the performance of the broader equity market.
Median Monthly Difference
Calculates the difference in the monthly performance of a sector compared with the broader equity market, and then takes the midpoint of those observations.
Price-to-Book (P/B) Ratio
The ratio of a company's share price to reported accumulated profits and capital.
Price-to-Earnings (P/E) Ratio
The ratio of a company's current share price to its reported earnings. A forward P/E ratio typically uses an average of analysts’ published earnings estimates for the next 12 mos.
Price-to-Sales (P/S) Ratio
The ratio of a company's current share price to reported sales.
The comparison of a security's performance relative to a benchmark, typically a market index.
Return on Equity (ROE)
The amount, expressed as a percentage, earned on a company's common stock investment for a given period.
A mathematical analysis that estimates the relative contribution of various sources of volatility.
Methodology Strategist View
Our sector strategist, Denise Chisholm, tracks key indicators that have influenced the historical likelihood of outperformance of each sector. This historical probability analysis informs the Strategist Views.
Sector rankings are based on equally weighting the following four fundamental factors: EBITDA growth, earnings growth, ROE, and FCF margin. However, we evaluate the financials and real estate sectors only on earnings growth and ROE because of differences in their business models and accounting standards.
Compares the strength of a sector versus the S&P 500 index over a six-month period, with a one-month reversal on the latest month; identifying relative strength patterns can be a useful indicator for short-term sector performance.
Valuation metrics for each sector are relative to the S&P 500. Ratios compute the current relative valuation divided by the 10-year historical average relative valuation, eliminating the top 5% and bottom 5% values to reduce the effect of potential outliers. Sectors are then ranked by their weighted average ratios, weighted as follows: P/E: 37%; P/B: 21%; P/S: 21%; and FCF yield: 21%. However, the financials and real estate sectors are weighted as follows: P/E: 65% and P/B: 35%.
Unless otherwise disclosed to you, any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity, is intended to be educational, and is not tailored to the investment needs of any specific individual. Fidelity and its representatives have a financial interest in any investment alternatives or transactions described in this document. Fidelity receives compensation from Fidelity funds and products, certain third-party funds and products, and certain investment services. The compensation that is received, either directly or indirectly, by Fidelity may vary based on such funds, products, and services, which can create a conflict of interest for Fidelity and its representatives. Fiduciaries are solely responsible for exercising independent judgment in evaluating any transaction(s) and are assumed to be capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies.
Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.
This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Investing involves risk, including risk of loss.
All indices are unmanaged. You cannot invest directly in an index. Index or benchmark performance presented in this document does not reflect the deduction of advisory fees, transaction charges, and other expenses, which would reduce performance.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.
Business Cycle Definition
The typical Business Cycle depicts the general pattern of economic cycles throughout history, though each cycle is different. In general, the typical business cycle demonstrates the following:
Early-cycle: The economy bottoms and picks up steam until it exits recession, then begins the recovery as activity accelerates. Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep.
Mid-cycle: The economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening.
Late-cycle: Economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing.
Please note that there is no uniformity of time among phases, nor is the chronological progression always in this order. For example, business cycles have varied between 1 and 10 years in the US, and there have been examples when the economy has skipped a phase or retraced an earlier one.
Market Indexes The Consumer Price Index (CPI) is a monthly inflationary indicator that measures the change in the cost of a fixed basket of products and services; the unadjusted number is often called "headline CPI." "Core CPI" excludes food and energy prices.
A Purchasing Managers' Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management® reports the US manufacturing PMI®.
The Russell 3000® Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the US equity market.
The S&P 500® index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. S&P 500 is a registered service mark of Standard & Poor’s Financial Services LLC. Sectors and industries are defined by the Global Industry Classification Standard (GICS).
The S&P 500 sector indexes include the standard GICS sectors that make up the S&P 500 index. The market capitalization of all S&P 500 sector indexes together comprises the market capitalization of the parent S&P 500 index; each member of the S&P 500 index is assigned to one (and only one) sector.
Sectors are defined as follows: Consumer discretionary: companies that provide goods and services that people want but don't necessarily need, such as televisions, cars, and sporting goods; these businesses tend to be the most sensitive to economic cycles. Consumer staples: companies that provide goods and services that people use on a daily basis, like food, household products, and personal-care products; these businesses tend to be less sensitive to economic cycles. Energy: companies whose businesses are dominated by either of the following activities: the construction or provision of oil rigs, drilling equipment, or other energy-related services and equipment, including seismic data collection; or the exploration, production, marketing, refining, and/or transportation of oil and gas products, coal, and consumable fuels. Financials: companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, and insurance and investments. Health care: companies in 2 main industry groups: health care equipment suppliers and manufacturers, and providers of health care services; and companies involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products. Industrials: companies whose businesses manufacture and distribute capital goods, provide commercial services and supplies, or provide transportation services. Materials: companies that are engaged in a wide range of commodity-related manufacturing. Real estate: companies in 2 main industry groups—real estate investment trusts (REITs), and real estate management and development companies. Technology: companies in technology software and services and technology hardware and equipment. Telecommunication services: companies that provide communications services primarily through fixed-line, cellular, wireless, high-bandwidth, and/or fiber-optic cable networks. Utilities: companies considered to be electric, gas, or water utilities, or companies that operate as independent producers and/or distributors of power.
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