Islands of opportunity for the rest of 2022

Financials, value, and small caps are strategist Denise Chisholm's top picks.

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Key takeaways

  • Financial stocks could shine in the second half of the year if improving credit conditions lead to lower losses on loans.
  • Value stocks are currently exceptionally cheap, which has historically often preceded periods of outperformance.
  • Small-cap stocks are currently pricing in extreme levels of fear. If that fear turns out to be overdone, small-cap stocks could also be posed to shine.

The first half of 2022 was rough for markets. Looking ahead to the rest of the year, many investors are worried about a potential cascade of problems. Some fear that stubbornly high inflation could force the Federal Reserve's hand into a hard landing, with rate hikes that send the economy into recession and stocks deeper into a bear market.

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But when it comes to investing, fear and worry can also be conducive to opportunity. Denise Chisholm is Fidelity's director of quantitative market strategy. She uses statistical analysis of market history and probabilities to inform her views on markets, sectors, investing styles, and more. Looking out at the remainder of this year, she sees 3 distinct potential areas that could be poised for outperformance.

1. The financial sector

Although investors tend to think of the financial sector as being largely driven by the direction of interest rates, Chisholm says that a different force—credit conditions—could help fuel outperformance in the sector over the second half of the year.

According to her analysis, the current environment looks ripe for credit spreads to fall. Credit spreads represent the difference in yields between higher- and lower-quality bonds (lower-quality bonds generally must pay higher yields to compensate investors for the higher likelihood of default). "Falling spreads indicate that investors expect fewer loan defaults, and reduced loan losses can help boost financial companies' earnings as well as their valuations," she says.

So why should credit spreads fall in the second half of the year? The economy is in strong shape, she says. And although inflation has been stubbornly high, she expects it to soften over the remainder of the year. Chisholm points out that expectations for future inflation have fallen, and some of the supply-chain issues fueling inflation have improved.

"My historical analysis suggests declining inflation could allow credit spreads to fall in the second half of 2022," says Chisholm. "I think that trend could produce a combination of higher valuations and stronger earnings for financial stocks, potentially helping them rally."

2. Undervalued stocks

Like financials, value tends to prosper when credit spreads fall, Chisholm says. Undervalued companies often have relatively weak finances—that's a big reason their stocks are cheap, she says. If credit spreads do shrink, it could reflect an improving outlook for weaker companies, potentially boosting the shares of value stocks.

"Historically, when long-term interest rates and credit spreads have fallen simultaneously, as I think is likely in the months to come, value stocks have outperformed growth stocks 65% of the time," Chisholm says.

What's more, she says value stocks look exceptionally cheap relative to the rest of the market. Chisholm measures this by focusing on the 25% of stocks in the S&P 500® with the lowest valuations based on price-to-earnings ratios. Compared to the S&P 500's median stock valuation, this group's average valuation is cheaper than it's been over 90% of its history, she says. Historically, under similar conditions, value has gone on to outperform the broad market by 8% over the next 12 months, on average—but past performance is never a guarantee of future results. 

3. Small-cap stocks

Shares of small companies are currently pricing in extreme levels of fear, Chisholm says. She measures investor fear with valuation spreads—the difference in valuation between the 25% of stocks that are most expensive and the 25% that are least expensive. "Wide spreads between those 2 groups happen when investors are scared into abandoning cheaper, riskier shares in favor of higher-quality, more expensive ones," she says.

Valuation spreads in the Russell 2000 small-cap index have recently been hitting exceptionally wide levels, signaling extraordinary fear. "When so much gloom and doom is priced into stocks, it's easy for conditions to turn out to be better than investors expect and to support higher prices," says Chisholm. "This setup makes me optimistic about small caps as a whole." She notes that in historical periods with similar levels of small-cap valuation spreads, shares of small companies averaged 30% returns over the following 12 months, on average.

Within small caps, Chisholm sees particular opportunity in undervalued stocks. According to her research, the least-expensive 25% of stocks in the Russell 2000 are the cheapest they've ever been on record, relative to the index's median stock. "If large-cap value looks like a bargain, small-cap value looks like a fire sale," she says.

Where to find ideas

Investors looking to increase their exposure to financials, undervalued stocks, or small-cap stocks can consider using the stock, mutual fund, and exchange-traded fund (ETF) screening tools on Fidelity.com. Here are some funds that appeared in the results of illustrative screens (which are not recommendations of Fidelity).

Financial-sector mutual funds

Top 3 results of a fund search screening for Fund Picks from Fidelity* that focus on the financial sector, with results sorted by 5-year returns:

  • Fidelity® Select Brokerage and Investment Management Portfolio (FSLBX)
  • T. Rowe Price Financial Services Fund (PRISX)
  • Fidelity® Select Financial Services Portfolio (FIDSX)

Large-cap value mutual funds

Top 3 results of a fund search screening for Fund Picks from Fidelity* that invest in large-cap value, with results sorted by 5-year returns:

  • Fidelity® Value Discovery Fund (FVDFX)
  • Fidelity® Equity-Income Fund (FEQIX)
  • American Funds American Mutual Fund® Class F-1 (AMFFX)

Small-cap value mutual funds

Top 3 results of a fund search screening for Fund Picks from Fidelity* that invest in small-cap value, with results sorted by 5-year returns:

  • Applied Finance Explorer Fund Investor Shares (AFDVX)
  • PIMCO RAE US Small Fund Class A (PMJAX)
  • Fidelity® Small Cap Value Fund (FCPVX)

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

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She uses history to share probability analysis on the US equity sectors.

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