Q3 sector scorecard: at the midpoint

Fidelity's latest quarterly sector update shows a mix of signals for most sectors.

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With stocks at all-time highs post-Brexit, investors may be wondering what segments could be poised to potentially lead the market higher in the second half of 2016—or which ones might provide some downside protection if the market overheats as this summer unfolds.

Fidelity's third quarter (Q3) sector update reveals that telecom has the most positive metrics of those measured in this report, followed by technology, consumer staples, and utilities. The energy and utilities sectors had the most negative metrics, despite being the two best performing sectors last quarter. Read on to see how the sectors were rated.

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.

Scorecard: positives for telecom, tech, and consumer staples

Telecom led all sectors with three positive metrics in Q2, but scorecard indicators and returns often did not align. For instance, technology had two positive and no negative metrics, but it had Q2's lowest return (-3%), as investors favored defensive stocks. Despite having three negative metrics each, energy and utilities were Q2's best-performing sectors.

Industries: top five & bottom five performers this quarter

In Q2, 43 of the 67 industries that comprise the MSCI USA Investable Market Index (IMI) had positive total returns, and 32 industries beat the broader market's 2.8% gain (MSCI USA IMI). The industry groups within utilities, telecom, energy, and materials all were positive in Q2. Consumer discretionary and technology were the only negative sectors for the quarter.

Sector considerations: energy fundamentals in focus

A business-cycle approach to sector allocation may produce excess returns, and the energy sector has traditionally outperformed during the late-cycle phase. The oil industry has continued to generate productivity gains in the largest basins throughout the price downturn, implying there may be opportunities for active security selection to identify relative winners.

Fundamentals: telecom, staples strong; technology mixed

Telecom fundamentals have been driven by enhanced earnings growth, while consumer staples ranks at or near the top on return on equity (ROE) and earnings per share (EPS). Tech leads on a free-cash-flow basis, but its earnings growth has turned negative. Energy had the highest performance of any sector in Q2, but energy fundamentals will recover more slowly.

Relative valuations: financials, tech still most attractive

Financials is the least-expensive sector based on price-to-book ratio and earnings yield, while technology offers compelling earnings and free-cash-flow yields. Although utilities and consumer staples look expensive relative to their historical averages, both tend to significantly outperform the broad market at this juncture in their valuation cycles

Momentum: defensive sectors maintain their lead

As they did in Q1, investors continued to favor more-defensive sectors in Q2. Therefore, telecom, consumer staples, and utilities once again were the top three beneficiaries of accelerated price momentum. By the same token, energy, materials, and financials repeated as momentum laggards, even though energy was far and away the best-performing sector in Q2.

Relative strength: telecom, staples, energy on the rise

Telecommunications and utilities had the highest levels of relative price strength compared to the S&P 500, while energy also fared well thanks to the sector's strong price appreciation (+16%) in the first two quarters of 2016. Financials was at the bottom of the pack, while price weakness in the biotech and pharmaceutical industries pressured the health care sector.

Evolution of real estate as the new 11th sector

On August 31, 2016, real estate will be elevated from an industry within the financials sector to its own individual sector. Most of the new sector will contain equity Real Estate Investment Trusts (REITs),* which historically have provided liquid and diversified property exposure, attractive dividend yields, and competitive long-term rates of total return.

Impact on financials sector when real estate is removed

When the real estate industry group is removed, the financials sector is likely to become less expensive on earnings and larger in average market capitalization (real estate stocks tend to have lower market caps than financials). It may also provide lower dividends than it had historically, while also exhibiting greater sensitivity to the stock market overall.

Defensive sectors: is it still a good entry point?

Is it cause for concern that some defensive sectors have forward valuations above their historical averages relative to the market? Actually, that's when some of these sectors have performed their best. Consumer staples and utilities, for example, historically have soundly beaten the S&P 500 during the 12 months after their forward P/Es eclipsed the market's average.

Health care: more than just pharma and biotech

Solid fundamentals—driven by strong employment and health care utilization trends, among others—have supported the performance of health care equipment and supplies. Employed individuals are more likely to have access to insurance, to visit the doctor, and to opt for elective procedures, which helps drive fundamental improvement for the companies.

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Bear Market
At least a 20% correction in the stock market.
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.
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 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 equity 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 mos.
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
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.
Business Cycle
The business cycle as used herein reflects fluctuation of activity in the U.S. economy and is based on Fidelity’s analysis of historical trends.
Sector rankings are based on equally weighting the following four fundamental factors: EBITDA growth, earnings growth, return on equity (ROE), and free-cash-flow margin. However, we evaluate the Financials sector only on earnings growth and ROE because of differences in its business model and accounting standards.
Compares the price change of a sector versus itself over a 12-month period, with a one-month reversal on the latest month. Persistence in returns can be a useful indicator of sector performance during a six- to 12-month period.
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 Index. 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: 35%; P/B: 20%; P/S: 20%; free-cash-flow yield: 20%; dividend yield: 5%. However, the Financials sector is weighted as follows: P/E: 59%; P/B: 33%; dividend yield: 8%.
Primary Contributors
Asset Allocation Research Team (AART)
AART is part of the Global Asset Allocation division of Fidelity’s Asset Management organization. AART conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity’s portfolio managers and investment teams.
Fidelity Management & Research Company Equity Division
The Equity Division within Fidelity Asset Management consists of 11 portfolio groups, as well as Select and Advisor Focus sector portfolios. Each group is responsible for portfolio management supported by in-depth fundamental research.
Fidelity SelectCo
SelectCo is a division within Fidelity’s Asset Management organization and is focused exclusively on expanding the company’s 30-year heritage of sector investing to help meet the evolving needs of investors and advisers for innovative sector-specific tools, resources, and products.
Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
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 indices are unmanaged. You cannot invest directly in an index. Index or benchmark performance presented in this document does not reflect the deduction of advisory fees, transaction charges, and other expenses, which would reduce performance.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.
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 that 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.
Market Indices
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.

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.
Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.
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Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

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