- Cyclical sectors generally continued to lead in the second quarter as the economic recovery gained momentum: Real estate and energy posted the first- and third-best performance, respectively, while technology surged after a weak Q1.
- Financials had cheapest relative valuations in Q2 for the fourth quarter in a row. The most expensive sectors were consumer discretionary, real estate, and industrials.
- Going forward, the energy sector may be in a particularly good spot due to disciplined spending and possible rising oil prices.
- Consumer discretionary stocks have had two advantages over consumer staples during periods of strong wage growth: greater consumption and more successful price raising to boost margins.
As the economic recovery gained momentum, cyclical sectors generally continued to lead in the second quarter, with real estate, technology, and energy posting the best performance. Consumer staples, utilities, and health care showed the least strength in the second quarter, though only utilities posted a negative return. 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 third quarter.
See our chart presentation for an in-depth analysis.
Performance summary: Defensives lag cyclicals
Cyclical sectors generally continued to lead in the second quarter as the economic recovery gained momentum. Real estate and energy posted the first- and third-best performance, respectively, while technology surged after a weak Q1. Consumer staples, industrials, and utilities trailed the market by the largest margin, though only utilities posted a negative return for the quarter.
Scorecard: Financials and energy on top
Financials screened well across all scorecard metrics, while cheap valuations may help the energy sector offset weaker fundamentals. Conversely, solid fundamentals among consumer discretionary stocks may help counterbalance the sector’s high valuations, leading to a constructive outlook. Conditions appear less favorable for real estate, where high valuations may hamper performance, and utilities, which is less likely than other sectors to benefit from the ongoing economic recovery.
Fundamentals: Strength in tech, financials, and discretionary
The technology sector again led the fundamentals rankings, topping the market in return on equity and free-cash-flow margin. Financials and consumer discretionary also scored relatively well on fundamental metrics. Real estate was the worst performer by fundamental measures, ranking last on EPS growth and second to last on return on equity, followed by energy and utilities.
Valuations: Financials, energy, and staples remain cheap
Financials had the cheapest relative valuations for the fourth quarter in a row. The sector ranked second-best based on price-to-book (P/B) and price-to-earnings (P/E) ratios, which continued to be at the very low end of their historical ranges. Energy and consumer staples stocks also looked relatively inexpensive. The most expensive sectors were consumer discretionary, real estate, and industrials.
Relative strength: Energy, financials, and real estate lead
The energy, financials, and real estate sectors exhibited the greatest relative strength over the past 6 months, the result of a rotation into cyclical stocks that began last fall. Conversely, the continued rotation away from defensive stocks put consumer staples in last place in relative strength, followed by health care and utilities.
Wages have accelerated
Wages have risen unusually fast compared with past recoveries. Wage growth was especially weak following the Great Recession: It accelerated during only 20% of the periods since then, versus roughly half the time since 1962. Strong wage growth historically has boosted cyclical sectors relative to defensives, and the effect since 2009 has been particularly strong.
For bond yields’ direction, check inflation expectations
The Core Consumer Price Index (CPI) rose 3.8% for the 12 months through May. Do yields follow? There’s been surprisingly little connection between the two, even at higher (top-quartile) inflation levels. Inflation expectations have had a stronger connection to yields. When expectations exceed 2.3%, and are in the top quartile as they are now, yields have tended to increase—even if the pace of expected inflation slows.
Earnings surprises could continue
S&P 500 companies have blown past analysts' earnings forecasts, with record numbers of firms beating expectations by more than 20%. Positive earnings surprises historically have legs: After reaching the top quartile of their historical range (as they did in Q1 2020), earnings beats have tended to stay above average for the following two-and-a-half years. Therefore, if history is a guide, positive earnings surprises could persist into next year.
Heed the bond market?
A high spread between the valuations of the stock market's most- and least-expensive quartiles suggests that equity investors are nervous. Yet high-yield credit spreads are low, indicating that credit investors aren’t worried. Historically, this setup has spelled opportunity: When equity spreads exceed credit spreads, stocks have advanced 90% of the time over the next 12 months.
Tail risk fears may be a good sign for equities
Skew, a statistic derived from the options market, measures investors’ perception of tail risk, or the risk of extreme market events. It’s very high currently, in the top decile of its historical range—and that may be a good sign for the stock market. Like many sentiment indicators, skew has often been useful as a contrarian signal, historically: In the past, the more concerned investors have been about tail risk, the shallower drawdowns have been.
Frugality may have made energy stocks resilient
Energy companies slashed their spending in recent years, helping them maintain positive free cash flow even as oil prices tanked last year. That marks the first time in four decades the sector generated free cash flow through a trough in oil demand. Now a combination of disciplined spending and rising oil prices could bode well for the sector.
Fast-rising wages have helped discretionary, not staples
Over the long term, wage growth hasn’t made much of a difference to the performance of the consumer sectors. That changed when wage growth became scarce following the Great Recession. During periods of strong wage growth since then, consumer discretionary usually has tended to beat the market while consumer staples usually has not.
Wage growth has boosted consumption and discretionary's margins
Consumer discretionary stocks have had two main advantages over consumer staples during periods of strong wage growth. High wage growth often drives greater consumption of discretionary items, and companies in the discretionary sector have been more successful at raising prices to boost margins during these periods.
Gold mining stocks may offer gleaming value
Gold mining stocks are in the cheapest 5% of their historical range on free cash flow (FCF). From such low valuations historically, the stocks have depended less on the price of gold than investors might think. Gold miners have outperformed 76% of the time after their FCF yield was in the top 5% relative to the market, including 71% of the time when the price of gold was falling.