It may be time to shine for cyclical sectors—at least that is one of the top line findings from the Q4 sector update. The performance of cyclical sectors follows the expansion and contraction of the business cycle and with the economy seemingly firmly in the early cycle phase, it could persist for a bit.
Among the other insights from Fidelity's sector strategist, Denise Chisholm:
- Tax increases may not be a drag on the market, and could encourage companies to invest.
- Rising earnings forecasts suggest further stock market gains ahead, despite likely election-induced volatility.
- A key valuation measure and low profit margins look bullish for industrials. Home prices look likely to rise and homebuilding stocks may be a value.
Find out how the 11 US stock market sectors fared in Fidelity's sector scorecard, followed by additional analysis from Denise Chisholm.
Scorecard: Investors stuck with cyclicals in Q3
The market continued to make up for lost ground in the third quarter, approaching pre-recession highs. Consumer discretionary (+15.1%), materials (+13.3%), and industrials (+12.5%) were the best-performing S&P 500 sectors for the quarter, while financials (+4.4%), real estate (+1.9%), and energy (−19.7%) performed worst. In the context of market history, current trends highlighted later in this report suggest that cyclical sectors may continue to generate strong returns in the months ahead.
Fundamentals: tech, consumer staples, health care led
Stock market fundamentals have been broadly challenged by the pandemic-induced recession. In fact, stocks have experienced their worst annual earnings growth since the global financial crisis. Among the 11 sectors, technology led our fundamentals ranking over the past 12 months. Consumer staples and health care also fared relatively well. Energy stocks continued to lag by most measures.
Relative valuations: Value in financials stocks
Financials looked inexpensive at the end of the third quarter, with price-to-earnings and price-to-book ratios near the low end of their historical range. Energy and health care stocks also traded at low valuations compared with their histories. By contrast, the utilities, industrials, and consumer discretionary sectors all looked relatively expensive.
Relative strength: discretionary, tech, and materials on top
Strong third-quarter and 6-month performance helped push consumer discretionary, technology, and materials stocks into the top 3 spots in our relative strength rankings. Utilities, real estate, and consumer staples exhibited weakness relative to the other market sectors.
Tax increases may not drag on the markets
Some investors have expressed concern that certain election outcomes could mean higher taxes that would hurt stock returns. Yet tax increases historically haven’t correlated with poor equity performance. In fact, the market gained during most previous years in which taxes rose, possibly in part because increased fiscal spending helped offset the tax impact. Although the sample size is relatively small, the data suggest that higher taxes may not imperil stocks.
Higher taxes may encourage corporate investment
Higher taxes also may increase companies’ incentive to invest in their own businesses. Real investment spending—the money companies invest in new equipment, factories, and the like—is near previous recessionary lows. Corporate investment spending has tended to grow faster in years when taxes increase, possibly because companies are incentivized to reinvest higher-taxed profits into their business rather than pay taxes on them.
Policy uncertainty has historically meant volatility, gains
The election in November makes future economic policy unclear. Stanford and the University of Chicago maintain an index of economic policy uncertainty; it’s now in the highest quartile of its historical range. Since 1985, periods with more uncertainty had higher odds of a market advance over the following year. They also had greater volatility—suggesting that investors may want to consider staying the course but should be ready to ride out some bumps.
Rising earnings forecasts appear supportive of further rally
Stock analysts have begun increasing their earnings estimates after lowering them earlier this year. Such upward inflections in earnings forecasts have historically happened in recessions, near the beginning of bull markets. Cyclical sectors have had a slight edge over defensives leading up to past inflections in forward earnings, as stock prices tend to anticipate future events, but that gap tended to widen significantly in the 12 months that followed.
A key valuation metric for industrials is flashing green
Historically, the relative price-to-sales (P/S) ratio has been the most predictive valuation metric for industrials. When industrials’ relative P/S ratios have been in the lowest quartile of their historical range in the past, the sector outperformed the market 71% of the time over the next 12 months. Industrials stocks currently sport their lowest P/S ratios in almost 20 years.
Are industrials’ low profit margins good news?
Industrials got inexpensive for a reason: Their profit margins have fallen swiftly and severely since mid-2019. While declines of this magnitude are rare, historically they have presented buying opportunities. Since 1950, industrials’ profit margins fell at least 2 percentage points year-over-year 8 times. Each time, the sector outperformed the market over the next 12 months. Falling profit margins in the rearview mirror have been even more predictive of gains than profit margins on the rise.
Home prices look likely to rise
The supply-and-demand picture may be constructive for the housing industry. Demand for housing has recovered quickly after a sharp drop-off earlier in the year, as low interest rates have helped push housing affordability near historic highs. At the same time, low homeowner vacancy rates indicate tight supplies. The combination of strong demand and low supply is likely to push up home prices, which could benefit homebuilding stocks.
Homebuilding stocks may be undervalued
Homebuilders have maintained strong free cash flow this year despite the recession. Strong financials have kept homebuilder valuations low even as their prices rallied, with their relative price-to-book ratios in the bottom quartile of their historical range. Homebuilders beat the market 80% of the time from these valuation levels in the past. Housing strength and homebuilder returns have historically been key drivers of broader consumer discretionary performance.
Next steps to consider
Get industry-leading investment analysis.
Get the details on the lineup of mutual funds.
She uses history to share probability analysis on the US equity sectors.