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Financials, health care, and consumer staples could be poised to lead.
Denise Chisholm, Director of Quantitative Market Strategy, Quantitative Research & Investments, Fidelity Management & Research Company
Energy and utilities stocks were the main outperformers in the first quarter, as oil and gas prices rose and investors sought defensive plays.
Looking ahead, a combination of low valuations and rising interest rates could give a boost to the financial sector.
The consumer staples and health care sectors could also offer opportunity. Both look exceptionally cheap relative to their own histories.
While many investors may be concerned about the impact of high inflation on markets, stocks have historically weathered inflationary periods well when the economy stays out of recession. Currently, the economy remains strong.
The first quarter this year saw some notable market shifts. Energy stocks experienced rapid price gains on rising oil and gas prices. And investors sought safety in defensive sectors amid rising market volatility, geopolitical tensions, and rising interest rates. But what sectors, factors, and themes could take leadership over the next few months? Fidelity's director of quantitative market strategy, Denise Chisholm, sees potentially favorable conditions ahead for the financial, health care, and consumer staples sectors.
Performance summary: The market gets defensive
Energy stocks led the market in the first quarter, as Russia's invasion of Ukraine sent oil and gas prices soaring. Defensive stocks also outperformed, with utilities and consumer staples coming in second and third, respectively, as the market declined. Communication services, consumer discretionary, and information technology were the bottom performers.
Scorecard: Favoring health care and financials
Low valuations in health care and financials have made those sectors appealing, while consumer discretionary's strong fundamentals may help the sector overcome high valuations. Energy and industrials also continue to look attractive. The utilities sector presents poor fundamentals and expensive valuations, earning it an underweight.
Fundamentals: Materials, discretionary, and tech lead
Materials led the fundamental rankings, coming in second in earnings-per-share growth and EBITDA growth. Consumer discretionary and information technology also scored well. Utilities were the worst-performing sector by fundamental measures, coming in ninth in earnings-per-share growth, EBITDA growth, and free-cash-flow margin. Real estate and consumer staples also posted relatively poor fundamentals.
Valuations: Financials, health care, materials look cheap
Financials continued to have the cheapest valuations at the end of the first quarter, ranking as the least expensive sector by price-to-earnings and price-to-book ratios. The most expensive sectors were consumer discretionary, utilities, and industrials.
Relative strength: Strength in energy, staples, and utilities
The energy, consumer staples, and utilities sectors exhibited the greatest relative strength over the past 6 months. Technology was weakest, followed by the consumer discretionary and communication services sectors.
Utilities on top in February, but perhaps not for long
Energy stocks have garnered a lot of attention, but in February utilities was the only sector with monthly returns in the 90th percentile of its historical range. In the past, powerful utilities rallies have signaled investors getting too defensive. The market typically has gained, and utilities have underperformed, in 12-month periods after top-decile monthly relative returns for the sector.
Rising rates may not be a problem
The Federal Reserve has begun hiking interest rates, trying to tamp down inflation that stems in part from rapid wage growth. That kind of scenario has worked out well for investors in the past. Historically, the market has been more likely to advance amid a tightening Fed and strong wage growth than when the Fed is accommodative and wage growth is weak.
This isn't the 1970s
Inflation is high and we are facing an energy supply shock. Are we heading into a replay of the energy crisis and bear market of the 1970s? It's unlikely. The US economy is far less dependent on energy imports than it was then, and stocks are much less expensive relative to bonds than they were 5 decades ago, so both look less vulnerable.
A strong economy trumps high inflation
In the past, the stock market has weathered high inflation well when the economy stays out of recession. Today, the economy is strong and healthy employment may bode well for future growth. I expect inflation to decline but stay above average levels. How far it falls will matter: Historically, annual inflation below 5% has corresponded with strong stock performance.
Global interest rates look bullish for financials
Financials have struggled with low interest rates in the US and negative rates around the world. Now yields are rising in the US and in Germany, and German bond yields have turned positive after languishing below zero for years. In the past, simultaneously positive and climbing yields in the US and Germany have been great news for financials, both domestically and in Europe.
Financials' valuations may position the sector to outperform
Financials also are very cheap relative to their own history. Bottom-decile valuations are uncommon, but when they've occurred, the sector historically has advanced 90% of the time over the following 12 months, outperforming the market by an average of 16%.
Consumer staples appear to be on sale
The consumer staples sector has been trading at an extreme discount to its own history, likely because its earnings growth has lagged far behind the market's in recent years. The combination of weak past earnings growth and rock-bottom valuations historically has been a buying opportunity.
Health care's setup looks similar
Like staples, health care has produced weak earnings growth relative to the market and sports a low valuation compared to its own history. Also like staples, the combination has tended to precede outperformance—and health care has the additional advantage of high and rising margins.
Low-volatility factor looks more appealing
The low-volatility factor has struggled over the last several years, as riskier fare has been relatively inexpensive. Now the relative valuations of high-risk stocks have risen, while low-vol factor valuations hover around their 50th percentile. Historically, the low-vol factor's odds of outperformance have improved when risk gets expensive, especially outside of recession.
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Cycle Hit Rate: Calculates the frequency of a sector outperforming the broader equity market over each business cycle phase since 1962.
Dividend Yield: Annual dividends per share divided by share price. Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA): A non-GAAP measure often used to compare profitability between companies and industries, because it eliminates the effects of financing and accounting decisions.
Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA): A non-GAAP measure often used to compare profitability between companies and industries, because it eliminates the effects of financing and accounting decisions.
Earnings-per-Share Growth: Measures the growth in reported earnings per share over the specified past time period.
Earnings Yield: Earnings per share divided by share price. It is the inverse of the price-to-earnings (P/E) ratio.
Enterprise Value: 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.
Free-Cash-Flow Margin: The amount of free cash flow as a percentage of revenue. High FCF margin often denotes strong profitability.
Free-Cash-Flow Yield: 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 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 months.
Price-to-Sales (P/S) Ratio: The ratio of a company's current share price to reported sales.
Relative Strength: 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.
Risk Decomposition: A mathematical analysis that estimates the relative contribution of various sources of volatility.
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.
Fundamentals: 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.
Relative Strength: 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.
Relative Valuations: 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%.
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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.
Past performance is no guarantee of future results.
Investing involves risk, including risk of loss.
All indexes are unmanaged, and performance of the indexes includes reinvestment of dividends and interest income, unless otherwise noted. Indexes are not illustrative of any particular investment, and it is not possible to invest directly in an index.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.
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.
The Russell 3000
Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the U.S. 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 U.S. 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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