After a tumultuous start to 2016, global stocks stabilized as winter wound down. While a number of global headwinds remain, the second quarter of 2016 appears to have begun with a more optimistic outlook than that which was present at the outset of the year.
For those investors that are interested in finding out which parts of the stock market may be best positioned for the current quarter, Fidelity's latest sector scorecard suggests that telecom joined technology as some of the more attractive Q2 sectors, based on five key factors.
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 10 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 five key factors: business cycle, fundamentals, relative valuations, momentum, and relative strength.
Scorecard: positives for telecom, tech, staples, and industrials
As the U.S. economy experiences a mix of mid- and late-cycle indicators, defensive sectors may be returning to favor. In Q1, for example, telecom, consumer staples, and utilities all gained momentum, while the momentum and relative strength of tech and consumer discretionary fell from positive to neutral. No metrics for energy and materials are positive at this time.
Industries: top five & bottom five performers this quarter
In Q1, 49 of the 67 industries that compose the MSCI USA Investable Market Index (IMI) had positive total returns and 46 outperformed the MSCI IMI’s 0.94% gain. All industries within the utilities, telecom, energy, and consumer staples sectors were positive, while some industries within financials and health care posted the quarter’s lowest returns.
U.S. business cycle: mix of mid- and late-cycle dynamics
U.S. recession risks remain low, but late-cycle indicators have risen in recent months. In the current environment, by choosing a blended portfolio of select sectors that have historically performed well during either the mid- or late-cycle phase, it may be possible to generate excess returns.
Fundamentals: telecom and consumer discretionary strong
Fundamentals for telecommunications have been driven by accelerated earnings per share (EPS) and solid free-cash-flow margins, while consumer discretionary has benefited from strong returns on equity and EBITDA growth. Energy continues to lag, plagued by an overabundance of oil supply and low commodity prices, and its fundamentals will take more time to turn.
Relative valuations: financials, tech are attractive
Financials is the least expensive sector based on price-to-book and earnings yield, while valuations for technology remain favorable as well. Utilities, consumer discretionary, and consumer staples are pricier by comparison, but not unreasonably so relative to history. Energy is expensive based on P/E and FCF yield, but is cheap based on P/B and other metrics.
Momentum: defensive-oriented sectors take the lead
Amid heightened volatility during the second half of 2015 and early 2016, investors turned to more-defensive, less-cyclical sectors such as telecom, consumer staples, and utilities, which have seen accelerated price momentum. While energy and materials were momentum laggards entering 2016, both have enjoyed a higher degree of price appreciation more recently.
Relative strength: telecom, staples, utilities on the rise
Similar to other metrics for Q1, recent shifts in relative strength generally favore defensive, less economically sensitive sectors. Telecom, consumer staples, and utilities all improved relative to the broader market in Q1. Financials and energy continue to lag, however, while recent price weakness in biotech stocks has weighed on the health care sector.
Sector considerations: think through the cycle
A disciplined business cycle approach to sector allocation can produce active returns by favoring industries that may benefit from cyclical trends. While the mid-cycle phase generally offers more limited opportunities for relative sector outperformance, inflation-sensitive sectors historically have provided consistently solid relative performance during the late-cycle phase.
Profit margin growth has stalled due to energy sector
Historically, declining profit margins have often coincided with the late-cycle phase. Faltering cyclical productivity growth, hampered by wage gains, is often a prelude to margin pressure. However, profit margins have remained high and relatively steady. In fact, excluding the energy sector, profit margins have reached a new cycle peak.
Gold prices boosted by market volatility, macro uncertainty
Entering 2016, gold was in a four-year slump as investors chased higher returns amid relatively calm markets. But when volatility surged in Q1, investors rushed to gold in a flight to safety, and its price jumped 17%. Gold prices are also driven by macro and supply/demand factors. For instance, real interest rates below 3% have historically been supportive of gold prices.
Gold miners: improving fundamentals, attractive valuations
After being squeezed by low gold prices for several years, gold stocks had strong performance in the first quarter. These companies received a boost from a significant reduction in capital expenditures and from an improved supply/demand picture. Gold mining stocks also were the cheapest they’ve been relative to the price of gold in more than 15 years.
A less cyclical consumer discretionary sector?
Before 2000, consumer discretionary was dominated by brick-and-mortar companies with heavy fixed assets, which hurt free cash flow (FCF). But since the e-commerce boom, companies have been able to reduce capital spending and generate more FCF, which could help sustain margin expansion and make the sector less economically sensitive than it used to be.
Business cycle definition
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 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.
Recession: generally, a period of declining economic activity. More specifically, it is identified as negative GDP in two successive quarters.
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. The Russell 3000® Index measures the performance of the largest 3,000 U.S. companies, representing approximately 98% of the investable U.S. equity market.
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. Technology: companies in technology software and services and technology hardware and equipment. Materials: companies that are engaged in a wide range of commodity-related manufacturing. 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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