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As economic growth was stunted amid supply chain disruptions in Q3, commodity-related cyclical sectors lagged, including energy, industrials, and materials. Instead, investors appeared to favor communication services, utilities, and health care which posted the best Q3 performance. Fidelity's sector strategist, Denise Chisholm, is bullish on the energy, financials, and consumer discretionary sectors. Find out why and what else to watch for in the fourth quarter.
Performance summary: Rotation out of commodity cyclicals
The S&P 500 eked out a small gain in the third quarter, as financials stocks led the market. Commodity-related cyclical sectors lagged, including energy, industrials, and materials. Instead, investors appeared to favor communication services, utilities, and health care. Utilities and health care are expected to hold up relatively well if economic growth proves disappointing.
Scorecard: Energy, financials, and discretionary on top
Low valuations continue to make energy appealing, while poor fundamentals may already be priced in. Recovering fundamentals boost the outlook for financial stocks, which could benefit further if interest rates rise. Consumer discretionary stocks have solid fundamentals, which may help offset high valuations. On the other hand, weak fundamentals and high valuations could be headwinds for utilities and real estate, especially if rates increase.
Fundamentals: Tech, materials, and consumer discretionary lead
Technology continued to lead the fundamental rankings, coming in first on return on equity and free cash flow. Materials and consumer discretionary also scored well. Real estate was again the worst performer by fundamental measures, ranking 10th in earnings per share and return on equity. Energy and utilities also placed low on the fundamental rankings.
Valuations: Energy, financials, and materials look cheap
Energy had the cheapest valuations, ranking least expensive by price-to-earnings (P/E), price-to-book (P/B), and free-cash-flow yield. Financials and materials also look relatively inexpensive. The most expensive sectors were consumer discretionary, real estate, and industrials.
Relative strength: Real estate, communication services, and tech led
The real estate, communication services, and technology sectors displayed the greatest relative strength over the past 6 months. Energy came in last, followed by industrials and materials.
Rate hikes to come may be a bullish signal
Interest rates increased considerably during the quarter, which made many investors nervous. But rising rates historically have coincided with good stock returns—likely because they tend to happen when the economy is strong. Since 1980, gross domestic product (GDP) growth accelerated 60% of the time and stocks gained 82% of the time when the 10-year Treasury yield rose year over year.
Peak growth concerns? Don't sweat it
Growth tends to slow in the mid-stages of economic cycles, which have historically been constructive periods for stocks. History shows how much the economy decelerating matters. When GDP growth has slowed to an annual rate above the usual soft landing of 2.5%—as it has during 3 quarters of the slowdowns since World War II—the market has advanced 75% of the time. That scenario appears likely this time, given the strength in the labor market.
Cyclicals likely still a good bet
In a decelerating economy, investors might think they should rotate away from cyclicals and into defensive sectors. Again, the degree of deceleration matters. When GDP growth has slowed to above 2.5%, cyclicals have outperformed defensive sectors 61% of the time with average outperformance of 1.3%.
First Fed rate hike has historically been bullish for cyclicals
Investors worried about rising rates in 2022 may question the wisdom of holding cyclicals, but rising interest rates don't necessarily signal a time to rotate into defensive stocks. In fact, since 1962, cyclical stocks have outperformed defensives considerably during the year before and after the first Federal Reserve (Fed) rate hike in an interest rate cycle.
This cycle isn't like the last one
This economic cycle is shaping up to be much different from the one that followed the Great Recession. The reason: inflation. A National Federation of Independent Business (NFIB) survey of small business pricing plans recently hit its highest level since the 1970s. Core inflation historically has jumped after the NFIB pricing survey has reached its top decile.
Higher inflation typically means higher rates
Top-decile NFIB pricing survey results have almost always meant higher interest rates. That kind of environment has had big implications for sector selection. Energy has had 69% odds of outperforming the broad market during the 12 months after top-decile NFIB pricing surveys, while technology beat the market in only 40% of those periods.
Time to rotate for higher rates?
High valuations on sectors that tend to outperform when rates are low—namely technology, utilities, and consumer staples—suggest the market isn't pricing in a rate increase. But stock investors often get this trade wrong: Rates tend to rise significantly after these sectors reach their top valuation quartile. By contrast, energy, industrials, and financials are inexpensive and have historically tended to benefit from higher rates.
Weak consumer confidence may be good for discretionary stocks
Consumer sentiment has plummeted, but that doesn't mean people will stop spending. Historically, spending has risen when sentiment improved, but hasn't dropped when it weakened. What's more, steeper declines in sentiment have been more likely to be followed by a rebound, driving up both spending and the prices of consumer discretionary stocks over the next 12 months, historically.
High price-to-book ratios haven't stopped tech in the past
High valuations based on book value don't necessarily signal that technology stocks are overpriced. The sector historically has fared well when its price-to-book ratio has been high relative to the market and less well when its P/B has been low. Take the last 3 years: Tech valuations based on book value looked very steep, but surging fundamentals led to all-time high margins and booming stock prices.
Trouble for tech: High P/E ratios
Forward price-to-earnings (P/E) ratios have been much more predictive for the technology sector than price-to-book value. For a decade, technology stocks have been unusually cheap on forward earnings, relative to the market. No longer: The sector's relative forward P/E is now in the most expensive historical quartile. Tech has fared poorly from these levels in the past, on average.
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Cycle Hit Rate: Calculates the frequency of a sector outperforming the broader equity market over each business cycle phase since 1962.
Dividend Yield: 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 Yield: Earnings per share divided by share price. It is the inverse of the price-to-earnings (P/E) ratio.
Enterprise Value: A measure of a company's total value that includes its market capitalization as well as short- and long-term debt and cash on its balance sheet.
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 Margin: The amount of free cash flow as a percentage of revenue. High FCF margin often denotes strong profitability.
Free-Cash-Flow Yield: 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 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 months.
Price-to-Sales (P/S) Ratio: The ratio of a company's current share price to reported sales.
Relative Strength: The comparison of a security's performance relative to a benchmark, typically a market index.
Return on Equity (ROE): The amount, expressed as a percentage, earned on a company's common stock investment for a given period.
Risk Decomposition: A mathematical analysis that estimates the relative contribution of various sources of volatility.
Strategist View: Our sector strategist, Denise Chisholm, tracks key indicators that have influenced the historical likelihood of outperformance of each sector. This historical probability analysis informs the Strategist Views.
Fundamentals: Sector rankings are based on equally weighting the following four fundamental factors: EBITDA growth, earnings growth, ROE, and FCF margin. However, we evaluate the financials and real estate sectors only on earnings growth and ROE because of differences in their business models and accounting standards.
Relative Strength: 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.
Relative Valuations: Valuation metrics for each sector are relative to the S&P 500. 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: 37%; P/B: 21%; P/S: 21%; and FCF yield: 21%. However, the financials and real estate sectors are weighted as follows: P/E: 65% and P/B: 35%.
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References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.
This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Past performance is no guarantee of future results.
Investing involves risk, including risk of loss.
All indexes are unmanaged, and performance of the indexes includes reinvestment of dividends and interest income, unless otherwise noted. Indexes are not illustrative of any particular investment, and it is not possible to invest directly in an index.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.
The Chicago Board Options Exchange (CBOE) SKEW Index is a measure of the perceived tail risk of the distribution of S&P 500 investment returns over a 30-day horizon. The index values are calculated and published by the CBOE based on current S&P 500 options market data.
The Consumer Price Index (CPI) is a monthly inflationary indicator that measures the change in the cost of a fixed basket of products and services; the unadjusted number is often called "headline CPI." "Core CPI" excludes food and energy prices.
A Purchasing Managers' Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management
reports the U.S. manufacturing PMI
The Russell 3000
Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the U.S. equity market.
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 indexes include the standard GICS sectors that make up the S&P 500 index. The market capitalization of all S&P 500 sector indexes together comprises 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.
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, and insurance and investments. Health care: companies in 2 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 2 main industry groups—real estate investment trusts (REITs), and real estate management and 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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