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Sector strategy: Defense, then offense

You may want to rotate into utilities now. Or raise cash to buy tech/industrials later.

  • Fidelity Active Trader News
  • – 04/17/2014
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After a seemingly endless and disruptive winter, a transition of leadership at the world’s most powerful central bank, and the ongoing confrontation in the Crimea, a late winter thaw saw stocks claw their way to new all-time highs yet again—before the April pullback.

The S&P 500 briefly flirted with 1900 for the first time ever at the end of March, led by an unusual suspect to spearhead a rally: Utility stocks have been the best performing sector in 2014, as of late April.1 Meanwhile, a long-time leader during the five-year bull run—consumer discretionary—has struggled thus far.

So, what’s ahead? And how can short- and longer-term investors position their portfolios?

Viewpoints checked in with two Fidelity sector strategists, portfolio managers Denise Chisholm and Roy Justice. They think stocks have limited upside in the coming months and may fluctuate in a trading range, with the possibility of a continuation of the current correction in play. Short term, they are defensive. But they see any pullback as an opportunity to potentially stock up on pockets of growth for the long term.

For nimble investors, they suggest a short-term rotation to defensive sectors like utilities and staples. For others, they say, taking some profits may make sense, and then if the market does pull back, bargain hunt for technology, industrial, and possibly some financial stocks for longer term growth.

Despite stocks touching new highs, you were cautious about markets. Why?

Chisholm: If you look at the last two years, the global growth story has been the predominant market driver. One problem, in our view, is that over the last four or five months, the legs of this global growth story are weakening. A change like this in a significant pattern typically coincides with a shift in market leadership, and potentially a more range-bound market.

Roy Justice: We’re basing our concern about the global equity markets off of the choppiness that began with emerging markets, and then moved to Europe and Japan. And we’ve seen this to some extent in the U.S. when consumer stocks cracked, that is, saw a recent halt to their bullish momentum. This was a sign to me that the previous uptrend may be reversing, because these stocks were a leader of the rally. I’m always on the lookout for when the leadership of a trend cracks, which could be a potential reversal.

After gaining more than 30% in 20132, consumer discretionary stocks have pulled back. Should investors consider trimming these positions?

Chisholm: I think that consumer discretionary stocks do not currently offer a very attractive buying opportunity. If you look back over the last several years when consumer discretionary has outperformed, you’ve had the perfect climate for these stocks: Sentiment indicators bottomed out and companies were generating high free cash flow. In fact, the last few years have been the first time since the 1960s that you actually had this sector consistently generating strong free cash flow. Both of those critical drivers have reversed, so I believe there’s a chance that 2014 could be difficult for consumer discretionary stocks.

Justice: From a technical perspective, if you look at the charts, what’s happened over the last few months is a pretty negative set up for discretionary stocks. This could last for the next few months. To be clear, I’m not so sure that the uptrend that started in 2008 for this group is over. However, I don’t think 2014 is going to be a very good year overall for discretionary, or at least for the first half of 2014, which is a stark contrast to the momentum this group has generally had for more than five straight years.

Meanwhile, utilities were a laggard last year and are the best performer in 2014 thus far. Do you see the momentum continuing for these stocks?

Justice: What we are seeing in the last few weeks is several segments of the market that have been leaders during the rally—biotech, internet, media, and broker-dealers within the financial sector, for example—appear to be unwinding. As a result, you are seeing a rotation towards defensive areas, such as utilities, as well as staples. These are two areas that Denise and I think are relatively well positioned right now.

I think these types of rotations happen at inflection points in the market. My view is that the market may experience some downward pressure through the end of spring, at least. Those defensive areas where investors are rotating into, like utilities, can be the leadership for a while. I don’t think they’re durable leadership. That is, they won’t be market leaders for the next year or two. But they could be for the next three to six months. I think investors who want to stay in the market may want to consider a rotation out of the prior high-fliers and into the defensive areas during this timeframe, if they haven’t already.

What about health care, which was the other big winner from last year and has done relatively well in the early part of 2014?

Chisholm: Health care is a unique sector in that it has been both “defense” and “offense,” historically. The best time to buy it, regardless of market conditions, has been at trough sales growth when it is also cheap on a free cash flow basis—the position we were in a year ago. Fundamentals are still positive, but given that we have exited the “sweet spot,” I think other sectors offer more compelling entry points.

So you think utilities and staples are the best positioned sectors right now?

Chisholm: Yes. I think there’s a good argument to be made that the return on equity for these stocks, which may be close to a near-term trough, could increase if the commodity complex stabilizes, and natural gas specifically stabilizes. Over the last decade, these factors have correlated to sector performance.

The consumer staples sector has struggled to outperform during tough times for emerging markets. These companies have spent a lot of capital to get international exposure, but have seen limited growth thus far, in my view. Consequently, you’ve seen returns stagnate over recent years. However, even considering these fundamental challenges, every stock has a price where investors may be willing to step in. Current valuation levels on both earnings and sales suggest consumer staples stocks generally can offer a solid risk-reward entry point.

Justice: I’d add that, even though Denise and I think these are the best positioned sectors right now, we would caution against investors loading up on these stocks if they don’t have the ability to get in and out, for whatever reason. Risk adverse active investors may want to consider selling open positions and raise cash, and then look to buy market weakness.

What about technology and industrials stocks?

Chisholm: I think both sectors are well positioned for the long term. Leading indicators continue to suggest a durable capital expenditures recovery in the U.S., which is an historic driver for both sectors. With that said, we think the crosscurrents of a global deceleration and a flatter yield curve will likely offer a better entry point in the coming months.

Justice: That points to the value of raising some cash right now, if you haven’t already. Coming out of a potential sell-off, that would give you the flexibility to target specific parts of the technology, industrial, and possibly financial sectors. This is a strategy I am thinking a lot about. Specifically, semiconductors and internet stocks are two of our favorite areas to look for buying opportunities when the broader market is in a healthier position.

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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 author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
1. Source: FactSet. Utility sector performance measured by the Utilities Select Sector of the S&P 500 Index, which gained 8.6% year to date as of April 8, 2014.
2. Source: FactSet. Consumer discretionary sector performance measured by the Consumer Discretionary Select Sector Index, as of the end of 2013.
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