Q4 2021 sector scorecard

Communication services, utilities, and health care led Q3 as economic growth slowed.

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Key takeaways

  • Q3 saw commodity-related cyclical sectors lag, including energy, industrials, and materials. Instead, investors appeared to favor communication services, utilities, and health care.
  • Weak fundamentals and high valuations could be headwinds for utilities and real estate, especially if rates increase.
  • Interest rates increased considerably during the quarter, which made many investors nervous. But rising rates historically have coincided with good stock returns.
  • High valuations on sectors that tend to outperform when rates are low—namely technology, utilities, and consumer staples—suggest the market isn't pricing in a rate increase.

As economic growth was stunted amid supply chain disruptions in Q3, commodity-related cyclical sectors lagged, including energy, industrials, and materials. Instead, investors appeared to favor communication services, utilities, and health care which posted the best Q3 performance. Fidelity's sector strategist, Denise Chisholm, is bullish on the energy, financials, and consumer discretionary sectors. Find out why and what else to watch for in the fourth quarter.

See our interactive chart presentation for an in-depth analysis.

Performance summary: Rotation out of commodity cyclicals

The S&P 500 eked out a small gain in the third quarter, as financials stocks led the market. Commodity-related cyclical sectors lagged, including energy, industrials, and materials. Instead, investors appeared to favor communication services, utilities, and health care. Utilities and health care are expected to hold up relatively well if economic growth proves disappointing.

Scorecard: Energy, financials, and discretionary on top

Low valuations continue to make energy appealing, while poor fundamentals may already be priced in. Recovering fundamentals boost the outlook for financial stocks, which could benefit further if interest rates rise. Consumer discretionary stocks have solid fundamentals, which may help offset high valuations. On the other hand, weak fundamentals and high valuations could be headwinds for utilities and real estate, especially if rates increase.

Fundamentals: Tech, materials, and consumer discretionary lead

Technology continued to lead the fundamental rankings, coming in first on return on equity and free cash flow. Materials and consumer discretionary also scored well. Real estate was again the worst performer by fundamental measures, ranking 10th in earnings per share and return on equity. Energy and utilities also placed low on the fundamental rankings.

Valuations: Energy, financials, and materials look cheap

Energy had the cheapest valuations, ranking least expensive by price-to-earnings (P/E), price-to-book (P/B), and free-cash-flow yield. Financials and materials also look relatively inexpensive. The most expensive sectors were consumer discretionary, real estate, and industrials.

Relative strength: Real estate, communication services, and tech led

The real estate, communication services, and technology sectors displayed the greatest relative strength over the past 6 months. Energy came in last, followed by industrials and materials.

Rate hikes to come may be a bullish signal

Interest rates increased considerably during the quarter, which made many investors nervous. But rising rates historically have coincided with good stock returns—likely because they tend to happen when the economy is strong. Since 1980, gross domestic product (GDP) growth accelerated 60% of the time and stocks gained 82% of the time when the 10-year Treasury yield rose year over year.

Peak growth concerns? Don't sweat it

Growth tends to slow in the mid-stages of economic cycles, which have historically been constructive periods for stocks. History shows how much the economy decelerating matters. When GDP growth has slowed to an annual rate above the usual soft landing of 2.5%—as it has during 3 quarters of the slowdowns since World War II—the market has advanced 75% of the time. That scenario appears likely this time, given the strength in the labor market.

Cyclicals likely still a good bet

In a decelerating economy, investors might think they should rotate away from cyclicals and into defensive sectors. Again, the degree of deceleration matters. When GDP growth has slowed to above 2.5%, cyclicals have outperformed defensive sectors 61% of the time with average outperformance of 1.3%.

First Fed rate hike has historically been bullish for cyclicals

Investors worried about rising rates in 2022 may question the wisdom of holding cyclicals, but rising interest rates don't necessarily signal a time to rotate into defensive stocks. In fact, since 1962, cyclical stocks have outperformed defensives considerably during the year before and after the first Federal Reserve (Fed) rate hike in an interest rate cycle.

This cycle isn't like the last one

This economic cycle is shaping up to be much different from the one that followed the Great Recession. The reason: inflation. A National Federation of Independent Business (NFIB) survey of small business pricing plans recently hit its highest level since the 1970s. Core inflation historically has jumped after the NFIB pricing survey has reached its top decile.

Higher inflation typically means higher rates

Top-decile NFIB pricing survey results have almost always meant higher interest rates. That kind of environment has had big implications for sector selection. Energy has had 69% odds of outperforming the broad market during the 12 months after top-decile NFIB pricing surveys, while technology beat the market in only 40% of those periods.

Time to rotate for higher rates?

High valuations on sectors that tend to outperform when rates are low—namely technology, utilities, and consumer staples—suggest the market isn't pricing in a rate increase. But stock investors often get this trade wrong: Rates tend to rise significantly after these sectors reach their top valuation quartile. By contrast, energy, industrials, and financials are inexpensive and have historically tended to benefit from higher rates.

Weak consumer confidence may be good for discretionary stocks

Consumer sentiment has plummeted, but that doesn't mean people will stop spending. Historically, spending has risen when sentiment improved, but hasn't dropped when it weakened. What's more, steeper declines in sentiment have been more likely to be followed by a rebound, driving up both spending and the prices of consumer discretionary stocks over the next 12 months, historically.

High price-to-book ratios haven't stopped tech in the past

High valuations based on book value don't necessarily signal that technology stocks are overpriced. The sector historically has fared well when its price-to-book ratio has been high relative to the market and less well when its P/B has been low. Take the last 3 years: Tech valuations based on book value looked very steep, but surging fundamentals led to all-time high margins and booming stock prices.

Trouble for tech: High P/E ratios

Forward price-to-earnings (P/E) ratios have been much more predictive for the technology sector than price-to-book value. For a decade, technology stocks have been unusually cheap on forward earnings, relative to the market. No longer: The sector's relative forward P/E is now in the most expensive historical quartile. Tech has fared poorly from these levels in the past, on average.

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

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