Q3 sector rankings: Tech remains strong

Industrials, Tech, Financials and other cyclicals may benefit from recent trends.

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Sector investors enjoyed another positive quarter for the market overall from April through June of 2017, with 9 of the 11 sectors enjoying positive performance, but only 4 sectors outperformed the broad market, led by Health Care, Industrials, and Tech.

Fidelity's Asset Allocation Research Team sees reasons why earnings growth may continue, though at a more moderate pace. (Read Viewpoints on Fidelity.com: European growth). 

Which sectors may potentially benefit? Here is an overview of recent sector performance, and some key themes that could shape sector performance in the months to come.

What is Fidelity’s Quarterly Sector Update?

The Quarterly Sector Update, including the Sector Scorecard, represents input from 2 discrete Fidelity investment teams—each with unique insights about sector investing—to provide a comprehensive view of the performance potential of the 11 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 4 key factors: business cycle, fundamentals, relative valuations, and relative strength.

Scorecard: Tech, Health Care, Consumer Discretionary led

Technology had 3 positive indicators in Q2, and was the top performer year to date (YTD). Health Care and Consumer Discretionary—second and third in YTD returns—also looked positive, with solid fundamentals and relative strength. Energy continued its decline, driven by falling oil prices and challenging supply/demand dynamics.

Fundamentals: Tech, Discretionary, Health Care look strong

Technology fundamentals looked solid in Q2, driven by accelerating EBITDA (earnings before interest, taxes, depreciation, and amortization) growth and healthy free-cash-flow margins. Consumer Discretionary and Health Care also scored well on multiple measures. Energy continued to lag, but moderating U.S. oil production and global crude stockpiles could be dynamics to watch moving forward.

Relative valuations: Financials, Telecom appear inexpensive

Financials had the lowest relative valuations of any sector in Q2, based on its low price-to-earnings (P/E) and price-to-book (P/B) ratios. Telecom also looked compelling on a P/E basis, but mixed on other metrics. Technology valuations have moved modestly above their historical averages due to strong recent outperformance.

Relative strength: Tech, Health Care, Discretionary on top

Technology led the pack through the first half of 2017, despite a pullback recently. Health Care rallied late in Q2, and Consumer Discretionary posted solid returns relative to the broader market. On the other hand, Energy and Telecom lagged. Financials also trailed the S&P 500 despite a more recent turnaround.

A recovery in investment spending may lift cyclicals

High-yield bond spreads tend to be leading indicators of corporate investment spending—money used to produce capital, goods, or services. High-yield spreads have fallen near historic lows, which suggests more availability of capital and may signal an approaching investment spending recovery—historically a boon for cyclical sectors.*

Easier lending standards may boost loan growth, Financials

Commercial and industrial loan creation has slowed in recent years, dragging down total loan growth. But improving lending standards could reverse that trend and bolster Financials stocks. Loan growth is a key driver for the sector, and can mean the difference between Financials outperforming or trailing the broader market.

Stability and valuations constructive for Industrials

The Industrials sector generates as much free cash flow as the defensive Consumer Staples sector, highlighting its stability relative to its more cyclical peers. Industrials is inexpensive relative to history based on its price-to-free-cash-flow ratio, among other valuation measures, and thus may be well-positioned for valuation multiple expansion.

Industrials operating margins could support gains

The Industrials sector appears uniquely positioned compared with other global cyclical sectors because it has had restrained capital spending. As a result, the operating margins and returns on equity of the businesses in the sector have been strong—constructive indicators of future performance.

Tech remains well-positioned

Concerns about a top-heavy market and a "FANG" bubble—an acronym for 4 popular tech stocks—appear overstated. Tech fundamentals remain strong and, despite recent gains, the sector's valuations are still near historical averages. When Tech has outperformed the broad market by more than 10% over 6 months, it often continued to beat the market.

Technology operating margins have strengthened

Since the dot-com era, the Tech sector has transformed. Technology stocks today are predominantly large companies with strong free cash flow and operating margins, versus the smaller, emerging, and highly volatile stocks of the late 1990s/early 2000s. Technology has historically outperformed when operating margins were rising.

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