While still positive for the year, US stocks are off their all-time highs set back in September amid slowing earnings growth and rising rates. There's been a fair amount of changes beneath the surface in recent months, including the reorganization of 3 of the 11 stock market sectors.
If you are reassessing the US stock allocation of your portfolio, Fidelity's latest sector scorecard suggests technology, consumer discretionary, and materials stocks may be best positioned for the coming months, based on 4 key factors. Read on to see where the 11 sectors stack up heading into the final stretch of 2018.
Most stock market sectors had a strong Q3, with technology, consumer discretionary, and health care leading since January 1. Tech and consumer discretionary had the most positive scorecard indicators and an overweight signal from our sector strategist, Denise Chisholm. Chisholm's view on each sector is presented in the "Strategist View" column on the right side of the scorecard. Materials had 2 positive metrics but remains a strategist underweight. Utilities and financials continued to face headwinds, but the outlook for financials is more constructive, according to our strategist.
Fundamentals: Materials, technology, discretionary strong
The fundamentals of the materials sector have continued to strengthen over the past 12 months, bolstered by solid EBITDA and EPS growth. Technology's fundamental strength remains broad-based, with solid free-cash-flow margin, EBITDA growth, and return on equity. Consumer discretionary has been supported by strong ROE. Conversely, the fundamental backdrops for the real estate, financials, and utilities sectors remain challenged.
Relative valuations: Telecom, materials near 10-year lows
The telecom and materials sectors appear inexpensive relative to other sectors, as their valuations are near the low end of their 10-year ranges. On the other hand, the technology, consumer discretionary, and industrials sectors are edging toward the high end of their 10-year valuation ranges.
Relative strength: Tech, discretionary, health care on top
Technology and consumer discretionary continued to lead the pack over the past 6 months. After a stellar third quarter, health care also rose into a leadership position. In contrast, the telecom, consumer staples, and financials sectors have lagged the broader market.
Rising earnings estimates a bullish signal for stocks
Analyst estimates of future corporate earnings tend to start high and decline over time as earnings announcements approach. But current estimates are rising, even through 2020, which has happened only 20% of the time since 1962 and has often led to above-average returns by the S&P 500 over the next 12 months. If earnings estimates are too low, as the trend suggests, forward valuations may be overstated—a constructive signal for stocks.
Low valuations suggest cyclical leadership will persist
As measured by free-cash-flow yield, cyclical sectors appear cheap relative to their defensive counterparts—which has historically been an indication that cyclicals will outperform. This suggests that the leadership of cyclical sectors will persist, and that the market may have already discounted some current investor concerns about issues such as trade policy, political and geopolitical risks, and weakness in emerging market stocks.
Signs of crowding could be constructive for health care
The valuation spread between health care stocks in the top and bottom quartiles on a forward-earnings basis is wide relative to history. This suggests that investors are crowding into certain stocks they perceive to be less vulnerable to the policy concerns and margin pressures facing the sector. Such crowding has been a constructive signal for the health care sector historically, and suggests that these concerns may already be priced in.
Commodity price gains don't always boost commodity stocks
Commodity spot prices have been in a secular decline relative to the S&P 500 price level. While commodity prices have risen recently, such price gains often fail to translate to the relative performance of the underlying equity sectors, such as energy and materials. This disconnect often stems from the relative valuations of the stocks themselves, and sectors like energy remain expensive compared to their long-term averages.
Sectors are shifting: The impact of the new GICS framework
MSCI and S&P Dow Jones announced changes to certain equity sectors as part of a revision of their Global Industry Classification Standard (GICS). To reflect recent market trends, including the broad integration of traditional telecom and media companies, the telecom sector was expanded to the "communication services" sector and includes certain stocks formerly classified within technology and consumer discretionary.
Tech margins, growth prospects may be lower after sector shift
With Internet companies shifting out of technology and into communication services, some investors are concerned about the outlook for the current technology sector. The sector's operating margins will be lower following the shift, and its expected earnings growth may also be reduced. But history suggests that these potential fundamental concerns may be offset by other signals that appear constructive for the sector.
Lower valuations may offset tech's slower growth outlook
The technology sector's relative valuations will also likely decline with the exclusion of Internet stocks. Lower valuations have historically led to higher odds of tech outperformance and thus may offset a lower growth outlook. Further, margin direction has been more important for tech than margin level. Because tech margins still appear to be in an expansionary trend and valuation support has strengthened, the sector's outlook remains constructive.
Next steps to consider
Open a Fidelity brokerage or other type of account to take advantage of sector investing opportunities.
Get the details on the lineup of mutual funds.
Learn more about sector investing