US stocks had a stellar first quarter, helping push the S&P 500, Dow, and Nasdaq back toward record highs. A noticeable recent drop in trading volumes has some investors wondering if this latest push to new highs has the legs to withstand some of the risks to the rally—including the United States' ongoing trade dispute with China and Europe, a maturing business cycle, global growth concerns, and some expensive stock valuations.
However, there are reasons to remain optimistic. If you are looking for new ideas, or are reassessing the US stock allocation of your portfolio, this report finds that stocks in the materials, staples, utilities, and energy sectors are among the most attractive, based on 4 key factors. Read on to see how the 11 sectors scored.
Scorecard: Strong cyclical rally in Q1, all sectors post gains
The Federal Reserve's pivot toward easier monetary policy helped cyclical sectors lead a market rally during the first quarter. Technology paced the market with a 19.9% gain on the quarter, followed by real estate (17.5%), industrials (17.2%), energy (16.4%), and consumer discretionary (15.7%).
Fundamentals: Communications, discretionary, materials lead
Communication services enjoyed strong return on equity (ROE) and growth in both EPS and EBITDA. Solid ROE also boosted the fundamental picture for the consumer discretionary sector, while materials showed strength in EPS and EBITDA growth. In contrast, the fundamentals of the real estate and financials sectors have lagged.
Relative valuations: Financials, materials are inexpensive
The financials and materials sectors appeared inexpensive as of the end of the first quarter, with valuations near the low end of their 10-year ranges. Energy valuations also screened low on a 10-year basis, but remain expensive compared to their longer-term averages. By contrast, communications services was near the most-expensive end of its 10-year valuation range.
Relative strength: Defensive sectors continued to gain
Despite strong performance by many cyclical sectors in the first quarter, utilities and consumer staples have showed strength relative to the broad market over the past six months, driven at least in part by the significant defensive rally in Q4. Real estate also performed well over the most recent six months, while energy, consumer discretionary, and financials trailed.
The economy may have room to grow
The current expansion is the longest since World War II, leading some to conclude that it can't continue much longer. But when measuring cycles from the start of one recession to the beginning of the next, the depth of the 2007–08 financial crisis suggests we may be only halfway through a typical progression. Consumer savings rates also rose more than usual and have stayed high. Consumer financial health may help cushion an eventual downturn.
Bad manufacturing news may be good news for cyclicals
Global manufacturing has slumped recently. That may be counterintuitive good news for cyclical sectors: Certain cyclicals—notably consumer discretionary, materials, technology, financials, and industrials—display a clear tendency to outperform during the 12 months following contractions in global manufacturing. Why? Possibly because weak backward-looking data boosts the odds of a manufacturing recovery in the months to come.
China's economy may be poised to improve
China has been ramping up efforts to stimulate its economy. Stimulus in China historically takes 12 to 18 months to affect growth, so its impact is likely to become evident later this year. Meanwhile, leading indicators in the country are improving. Loan approvals typically lead loan demand, so a recent jump in approvals could contribute to greater demand and spending later in 2019.
When growth in Asia is accelerating, cyclicals tend to lead
China's recovery appears likely to have support from the rest of the region. Leading indicators in the five major Asian economies have started to pick up. Historically, cyclical sectors have tended to lead the market in the 12 months after those indicators have accelerated from negative levels.
Emerging markets' low relative valuations may suggest a rally
Emerging market stocks are currently trading at historically low valuations relative to US stocks. In the past, relative valuations at extreme lows dramatically improved the odds that emerging markets would outperform the US over the subsequent months. In addition, strong returns from emerging markets stocks have tended to benefit the US materials sector.
Weak retail sales often a contrarian buy sign for discretionary
A drop in December's real retail sales led to hand-wringing about consumer discretionary stocks. But, interestingly, a contraction in real retail sales has not been negative for the sector’s performance historically. In fact, consumer discretionary has been the sector most likely to outperform the broader market following declines in real retail sales.
High valuations haven't been a negative sign for discretionary
Investors who are bearish on consumer discretionary stocks may note that the sector’s valuation is high relative to its history. Yet, history also suggests that high valuations are a reason to be bullish on the consumer discretionary sector: It has been more likely to outperform the market from its most-expensive levels than from its leastexpensive levels.
The key metric is earnings, and they're on the rise
History suggests that investors care less about stock prices within the consumer discretionary sector and more about the companies' ability to generate earnings. The sector's relative earnings growth has jumped recently—and in the past, when relative earnings have accelerated outside of recessions, consumer discretionary has led the broad market almost three-quarters of the time.
Tech still cheap relative to the long term, with better margins
Despite technology stocks' gains in recent years, their valuations remain low compared to their long-term averages. The reason: Tech companies grew their earnings as their share prices rose. Today, technology stocks offer a potentially appealing combination of low valuations and steadily increasing margins.
Next steps to consider
Get industry-leading investment analysis.
Get the details on the lineup of mutual funds.
Learn more about sector investing.