Sector rankings: Materials, staples take lead

Sector outlooks shifted in the wake of a turbulent finish to 2018.

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The S&P 500 lost 6% last year, as health care, utilities, and consumer discretionary were the only sectors to post gains during the year, on a total return basis. Meanwhile, the majority of sectors incurred double-digit declines as stocks went into a tailspin to close 2018.

Consequently, the picture looks markedly different in 2019, relative to Fidelity's last quarterly sector update. Moreover, if you haven't done so already, the start of a new year can be an opportune time to reassess the US stock allocation of your portfolio. This latest report finds that stocks in the materials and consumer staples sectors may be best positioned for the beginning of 2019, based on 4 key factors. Read on to see how the 11 sectors scored.

Scorecard: Only health care, utilities, discretionary up in 2018

Weakening global growth prospects and US monetary tightening contributed to a market decline late in 2018 and investors gravitated toward defensive sectors. On a 1-year basis, health care led the market with a 6.5% gain, utilities finished up 4.1%, and consumer discretionary eked out a positive 0.8% return. While the US business cycle is maturing and late-cycle conditions have taken hold, our sector strategist remains bullish on cyclicals entering 2019.

Fundamentals: Technology, communication services, materials strong

Despite recent negative results, the fundamentals of the technology sector remain strong, driven by solid free cash flow (FCF) margin, return on equity, and EBITDA (earnings before interest, tax, depreciation, and amortization) growth. The communication services and materials sectors also look attractive from a fundamental perspective. Conversely, the fundamental backdrops for real estate and utilities appear weak relative to other sectors.

Relative valuations: Energy, financials, materials look cheap

The energy, financials, and materials sectors are currently near the low end of their 10-year valuation ranges. However, energy in particular still appears overvalued based on a longer-term view. The current valuations of communication services, health care, and consumer discretionary appear somewhat elevated compared with their 10-year averages.

Relative strength: Health care, staples, utilities on top

Health care, consumer staples, and utilities have had the strongest performance over the past 6 months, as investors sought exposure to more defensive sectors when volatility rose during the second half of 2018. Cyclical sectors, including materials and technology, have lagged in recent months, and energy trailed the market at least in part due to Q4's steep decline in oil prices.

When defensive valuations jump, it's often good for cyclicals

Investors flocked to defensive sectors as volatility rose late in 2018. In fact, consumer staples, health care, and utilities valuations jumped by more than 20% relative to the broader market. Such sharp revaluations of defensive sectors have historically led cyclicals to outperform by 3% on average over the next 12 months, and that average jumped to 10% when defensive relative valuations also neared historic highs (as they have recently).

The gap between long and short-term rates still positive

In Q4, the Fed hiked rates for the ninth time this cycle, causing part of the Treasury yield curve to temporarily invert. An inverted curve means that longer-term bond yields are lower than shorter-term yields. But this inversion was short-lived and only affected the short end of the curve (durations of 2 years or less).* Generally, until multiple key yield-curve measures invert (meaning that most of the curve is inverted), recession risk remains low and cyclicals tend to outperform.

What does an inverted yield curve really mean for stocks?

When most of the yield curve is inverted (e.g., 10-year Treasury yields are lower than 2-year Treasury yields), stock returns are less likely to be positive than when the opposite is true. And although yield-curve inversions often precede recessions, the length of time between an inversion and the start of a recession has varied significantly throughout history. Thus, S&P 500 returns following an inversion have also varied greatly, but averaged a healthy 9.6% over the next 12 months.

Falling oil prices, slowing inflation could benefit cyclicals

Declining oil prices (similar to what we've seen recently) have often contributed to deceleration in both headline and core inflation. We entered 2018 expecting inflation and wage growth to accelerate. In 2019, wage growth is likely to continue to accelerate but inflation may decelerate due to lower oil prices. When inflation has been below 3% and slowing historically, cyclical sectors have benefited, especially consumer discretionary and technology.

Lower rate expectations, oil prices bullish signals for stocks

The Fed considers many variables in its management of short-term interest rates, but employment and inflation are its 2 key considerations. Of the 2, inflation has tended to carry more weight historically. A shift from accelerating to decelerating inflation will likely lower the trajectory of the federal funds rate, which has historically been a bullish signal for stocks outside of recessions, as have falling crude oil prices.

Oil prices may bounce back, but energy stocks may not

Oil prices tend to rally the year after they decline sharply. However, gains in crude oil prices often fail to translate to the relative performance of energy stocks. In fact, energy stocks often trail the market by nearly 6% following significant declines in crude oil prices. This disconnect often stems from the sector's relative valuation, and energy stocks in general remain expensive compared to their long-term averages, based on multiple measures.

Oil oversupply has plagued energy stocks

Oversupply has been a key driver of recently declining crude oil prices. Supply increases have historically been worse for energy stocks than demand declines because demand for oil has never declined for longer than one year. Thus, investor expectations tend to improve as anticipation builds for demand to rise again, often leading to rising valuations. But valuations tend to fall following supply increases and performance tends to deteriorate further.

Inflation-adjusted short rates are more predictive for tech

The real federal funds rate (the effective fed funds rate minus the core inflation rate) has often been a strong indicator for cyclical sector performance and for technology in particular. The real fed funds rate currently stands just above zero; when it has been below 2% historically and rising, technology stocks have tended to outperform. This suggests that recession risk remains low and may be a constructive signal for technology moving forward.

Results from stimulus in China likely to emerge in 2019

China entered a growth recession in 2018 and policymakers there have taken measures including lowering taxes and reducing bank reserve requirements, among others, to try and reinvigorate growth. (Trade sanctions may be a potential offsetting force.) Results from this monetary policy easing still remain elusive, but it has historically taken up to 18 months for industrial production in China to pick up following such measures, which often eventually benefits US cyclical sectors and technology in particular.

A compelling valuation backdrop for materials

Two important valuation indicators appear constructive for the materials sector. First, its relative valuation is near historic lows. Second, the valuation spread between the cheapest and most expensive materials stocks is wide relative to history. This signals that investors are crowding into stocks they perceive to be more defensive and suggests that concerns may already be priced in. Signs of crowding are present in the broader market right now, but more pronounced for materials.

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