Stocks got off to their worst start since the Great Depression: The S&P 500 lost 7%, as of January 26, after finishing marginally in the green during 2015. As bulls and bears battle for control of the market, it may now be more important to be selective in your investment decision making than at any point during the nearly seven year rally.
For the first time in our Quarterly Sector Update, one sector appears attractive from all five metrics that are measured in this report—technology.
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.
Q1 2016 scorecard: Positives for tech, consumer discretionary, and health care
All 10 sectors had positive returns in 2015’s final quarter, and six of the 10 sectors beat the S&P’s Q4 gain of 7%. Technology now reflects constructive signals on all five metrics, with momentum and relative strength turning positive. Materials was the quarter’s top performer, but commodity price weakness and ongoing supply/demand concerns still challenge the sector.
Industries: Top five and bottom five performers
In Q4, 50 of the 67 industries that compose the MSCI USA Investable Market Index (IMI) were positive on a total-return basis, and 23 industries outperformed the 6.2% return for the broader market (MSCI USA IMI). Note that the exhibit below uses a different benchmark index than the sector exhibit above. All industries within the health care and consumer staples sectors had positive Q4 returns. For the most part, industries connected to the energy sector struggled the most.
Business cycle: intermediate-term cycle view
A disciplined business-cycle approach to sector allocation can produce positive active returns by favoring industries that may benefit from cyclical trends as well as disfavor (e.g., underweight) relatively unattractive sectors. By choosing a blended portfolio of select sectors that have historically performed well in the current and potentially upcoming cycle phases, it may be possible to generate excess returns.
Fundamentals: technology and consumer discretionary on top
The technology and consumer discretionary sectors have benefited from positive fundamentals over the past year, boosted by strong free-cash-flow margins and earnings growth, respectively. Energy continues to have the weakest fundamentals overall, with persistently low oil prices and unfavorable supply-demand conditions hampering the sector.
Relative valuations: financials, telecom, technology attractive
Technology relative valuations remain compelling, while financials and telecom are the least expensive sectors based on earnings yield and cash-flow yield. Energy looks expensive based on these metrics, but on a price-to-book (P/B) basis the sector is at its cheapest level in 50 years. Valuations for the three best-performing sectors of the year—consumer discretionary, health care, and consumer staples—are higher but not unreasonable relative to history, as illustrated by the chart below which looks at a 10-year range.
Momentum: consumer discretionary and technology lead
After a challenging Q3, consumer discretionary and technology rebounded in Q4 and ended 2015 with strong momentum. Health care was also a leader, but not to the degree it was at the year’s mid-point. Energy was the biggest laggard, due to slowing demand from China and low oil prices. Materials also struggled for the year overall despite a sharp rally in Q4.
Relative strength: technology and consumer sectors strong
The tech sector’s strength rose steadily in the second half of 2015, while consumer staples spiked higher more recently. Consumer discretionary also had a good showing. Despite having one of the highest returns for the period, Health care’s relative strength ended lower than it began, while energy and materials continued to decline in the back half of 2015.
Financials: loan growth driving multiple expansion?
Within financials, improving loan growth has historically been a strong indicator of the potential for higher valuations. Considering that net interest margins for regional banks have been well below historical averages, increases in interest rates could potentially provide a boost to this group, whose lending earnings are typically reliant on loan spreads.
Consumer stocks tend to outperform when earnings slow
Corporate earnings have decelerated from their mid-cycle peaks of late. In such environments, consumer stocks historically have beaten most other sectors. Along with health care, consumer staples and consumer discretionary have outpaced the broader market roughly 60% of the time over the past 50 years, and their overall returns are also higher than the market’s.
Staples: historically attractive valuations and improving return on equity (ROE)
In addition to its favorable historical performance when the market’s earnings decelerate, the consumer staples sector looks fairly valued based on its long-term averages. In addition, the sector’s return profile has been trending positively recently. These factors may present a potentially attractive entry point for investors, based on valuation and improving return on equity.
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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