U.S. stocks have moved sideways since reaching all-time highs earlier this year, as of mid April, with the energy and telecom sectors displaying the most weakness. However, there remain a number of reasons to be cautiously optimistic about this eight-year bull market.
If you are looking to assess the composition of your portfolio, or you are seeking new opportunities, here are some key sector themes to think about during the second quarter.
What is Fidelity’s Quarterly Sector Update?
The Quarterly Sector Update, including the Sector Scorecard, represents input from three discrete Fidelity investment teams—each with unique insights about sector investing—to provide a comprehensive view of the performance potential of the 11 major U.S. equity market sectors over multiple investment horizons. The Sector Scorecard’s proprietary methodology measures the relative attractiveness of each sector as measured by four key factors: business cycle, fundamentals, relative valuations, and relative strength.
Scorecard: tech, financials, and industrials all positive
The technology, financials, and industrials sectors each had two positive indicators in Q1, and tech had the best return of any sector. Health care rallied after a disappointing 2016, and both consumer sectors displayed strong fundamentals. Energy slipped in Q1, pressured by falling oil prices and higher-than-hoped-for production levels.
Fundamentals: health care, consumer sectors strong
Health care had strong fundamentals in Q1, benefiting from healthy earnings per share growth and free cash flow. Consumer discretionary and consumer staples also scored well, notably in return on equity. Energy fundamentals slipped in Q1 as oil prices trended downward and supply remained robust.
Relative Valuations: financials, real estate tie for top spot
The financials and real estate sectors had the lowest relative valuations of any sectors in Q1, based on their compellingly low price-to-book (P/B) ratios and above-average earnings yields. Conversely, the energy sector continues to send mixed signals, with a high P/E ratio but weak earnings and free-cash-flow yields.
Relative strength: cyclical sectors remain in favor
The strong defensive rally during much of 2016 continued to fade from memory by Q1 2017. Cyclical sectors, such as financials, technology, and industrials, posted the strongest performance relative to the broad market. Less economically sensitive sectors were generally not as competitive with the S&P 500 during the past six months.
Tax reform may help drive a corporate profit recovery
Cyclical sectors have outperformed when corporate taxes have fallen. Lower taxes lift corporate confidence, a catalyst for investment spending and profit recoveries, which tend to begin prior to actual reform. Starting points matter: When corporate earnings were previously in decline, earnings growth recoveries tend to be more durable.
Investment spending supports financials, discretionary
Investment spending—money used to produce capital, goods, or services—has been weak in recent years. But investment spending recoveries can be stimulated by profit recoveries. Financials and consumer discretionary have had the highest odds of outperforming the S&P 500 Index just before and during investment spending recoveries.
Improved credit, steeper yield curve drive financials sector
Profit recoveries have often coincided with improved credit and a steeper yield curve, meaning long-term rates are increasing relative to short-term rates. Improved credit typically causes the valuations of financials stocks to expand, while a steeper yield curve tends to coincide with an acceleration in profits for the financials sector.*
Financials: outperformance…and then some
The financials sector is unique in two ways: When it has beaten the S&P 500 over a six-month period*, it’s beaten it again over the next six months almost 70% of the time. No other sector has shown this same tendency. And when financials outperform the S&P 500, the sector typically beats the returns of other cyclical sectors as well.
Utilities tend to lag in a profit recovery & when rates rise
Over time, the sector least likely to outperform during a profit acceleration is Utilities. Because it has historically been a slow, steady grower, the sector’s relative earnings have trailed those of its higher-growth peers when profits improve. Utilities also is one sector where rising interest rates have clearly coincided with its underperformance.
- Find sector strategy ideas.
- Read Viewpoints: "Business cycle update: U.S. economy remains strong."
At least a 20% correction in the stock market.
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 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 per share divided by share price. It is the inverse of the price-to-earnings (P/E) ratio.
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 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.
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
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.
The business cycle as used herein reflects fluctuation of activity in the U.S. economy and is based on Fidelity’s analysis of historical trends.
Sector rankings are based on equally weighting the following four fundamental factors: EBITDA growth, earnings growth, return on equity (ROE), and free-cash-flow margin. However, we evaluate the Financials sector only on earnings growth and ROE because of differences in its business model and accounting standards.
Compares the price change of a sector versus itself over a 12-month period, with a one-month reversal on the latest month. Persistence in returns can be a useful indicator of sector performance during a six- to 12-month period.
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 Index. 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: 35%; P/B: 20%; P/S: 20%; free-cash-flow yield: 20%; dividend yield: 5%. However, the Financials sector is weighted as follows: P/E: 59%; P/B: 33%; dividend yield: 8%.
Asset Allocation Research Team (AART)
AART is part of the Global Asset Allocation division of Fidelity’s Asset Management organization. AART conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity’s portfolio managers and investment teams.
Fidelity Management & Research Company Equity Division
The Equity Division within Fidelity Asset Management consists of 11 portfolio groups, as well as Select and Advisor Focus sector portfolios. Each group is responsible for portfolio management supported by in-depth fundamental research.
SelectCo is a division within Fidelity’s Asset Management organization and is focused exclusively on expanding the company’s 30-year heritage of sector investing to help meet the evolving needs of investors and advisers for innovative sector-specific tools, resources, and products.
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: 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: 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 one and 10 years in the U.S., and there have been examples when the economy has skipped a phase or retraced an earlier one.
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 indices include the standard GICS sectors that make up the S&P 500 Index. The market capitalization of all S&P 500 sector indices together composes 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.
MSCI USA Investable Market Index (IMI) is designed to measure the performance of the large-, mid-, and small-cap segments of the U.S. market. With 2,505 constituents, the index covers approximately 99% of the free-float-adjusted market cap in the U.S.
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, insurance and investments, and real estate, including REITs.
Health Care: companies in two 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 two main industry groups—real estate investment trusts (REITs), and real estate management & 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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