US stocks are in the black for 2018, as of mid-April, as investors grapple with persistently strong corporate earnings and political/geopolitical headlines, among other factors.
Amid this backdrop, Fidelity's 2nd quarter sector scorecard finds positive metrics for most sectors, particularly technology and consumer discretionary stocks. However, most sectors also have one or more negative marks, suggesting investors should stay vigilant on this market. Read on to see how each sector stacked up in our latest scorecard, and what to keep an eye on as the quarter unfolds.
Scorecard: technology and discretionary on top
US tax cuts and fiscal stimulus helped firm inflation and growth expectations early in Q1, pushing the stock market higher. Then accumulating uncertainties and risks drove volatility up and prices down, with 9 of the 11 equity sectors closing Q1 in negative territory. Technology and consumer discretionary had positive quarters and remained scorecard leaders despite elevated valuations. Utilities had three negative indicators at the end of Q1.
Fundamentals: tech, discretionary, materials looked strong
The fundamentals of year-to-date return leaders technology and consumer discretionary continued to impress during Q1, but materials showed the most strength, boosted by solid EPS and EBITDA growth and free-cash-flow margin. On the other hand, real estate and financials fundamentals weakened relative to the other sectors.
Relative valuations: telecom, financials, real estate look attractive
Based on our framework, the telecom, financials, and real estate sectors are currently trading at the lowest relative valuations, based largely on their compelling earnings and dividend yields. The valuations of the technology, industrials, and consumer discretionary sectors are somewhat elevated relative to their historical averages due to strong recent performance.
Relative strength:Technology, discretionary, and financials led
The technology, consumer discretionary, and financials sectors continued their steady leadership in Q1, while consumer discretionary joined the top three sectors after inflecting higher and resuming its long-term uptrend. Defensive sectors—utilities, real estate, and telecom, in particular—continued to lag the market, with no sign of a change in trend.
Corrections are common and have been buying opportunities
The S&P 500 dropped 10% in just nine trading days in February, following 18 months without a true correction (only 8.5% of calendar years since 1962 have had less than a 5% market correction). But corrections have occurred quite frequently throughout history and have often created buying opportunities. In fact, 10+% corrections have happened in nearly 60% of the years since 1962, yet stock returns were positive in 75% of those years.
Was this sharp correction different than past pullbacks?
Many investors were concerned about February's unusually quick pullback, and wondered whether it was a bearish signal for stocks. However, although sharp corrections are somewhat rare (they have only occurred in nine years since 1962), they have happened more often during bull markets than during bear markets, and thus have often presented buying opportunities historically.
Rising rates are often a sign of growth, not a deterrent to it
Some have said that higher interest rates and rising inflation expectations contributed to the February pullback. The yield on the 10-year Treasury rose by 35% in six months (albeit from a very low base). But contrary to the conventional wisdom, higher rates have often been constructive for stocks—a reflection of growth rather than a hindrance to it.
Lower personal income taxes may boost consumer sectors
Personal tax reform has generally not been a broad-market-moving event historically, but it has benefited the consumer sectors—consumer discretionary, in particular. Following reductions in personal tax rates, consumer discretionary has outpaced the market the vast majority of the time and its relative returns have been strong.
Credit growth appears poised to accelerate
As the US consumer has delevered since 2009, credit growth has been lackluster relative to prior credit recoveries, and has likely been a drag on the relative earnings growth of consumer discretionary stocks. Even if credit growth remains low compared to prior recoveries, if historical trends persist, we may be nearing a second credit acceleration, which have tended to occur approximately 10 years into credit recoveries.
Rates no longer a headwind for consumer discretionary
The consumer discretionary sector has changed its stripes over the years and is now largely composed of mature companies with strong free-cash-flow yield and higher margins. This transformation might explain why the performance of consumer discretionary stocks when interest rates are rising has improved over time.
Flattening yield curve not constructive for consumer staples
In part, the bond yield curve—the difference between short-term and long-term interest rates—is an indicator of future economic growth expectations. When short-term yields rise faster than long-term yields, the yield curve is said to be "flattening." Many investors take this as a signal of weakening growth expectations, which tend to favor defensive sectors. But consumer staples has generally not outperformed the market amid a flattening yield curve.
Do low valuations suggest a good entry point for staples?
Consumers staples stocks appear inexpensive based on their forward price-to-earnings (P/E) ratios. However, the sector's likelihood of outperformance only increased by five percentage points when its valuations were in the bottom quartile. In other words, valuation alone has not been a significant driver of consumer staples performance.
Margins are a more important driver for consumer staples
Historically, whether profit margins were rising or falling has been a significant indicator of consumer staples performance, often meaning the difference between the sector out- or underperforming. Increased pricing pressure as a result of heightened competition has hurt staples margins, creating challenges for the sector.
Next steps to consider
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