Sector rankings: Tilted toward tech

Tech, energy, and consumer discretionary score most positive marks.

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Amid tension-filled trade talk, another Fed rate hike, and earnings season getting underway, investors have a lot to digest right now as the US stock market flirts with record highs just past the midpoint of the year.

If you are reassessing the US stock allocation of your portfolio, Fidelity's latest sector scorecard suggests technology, energy, and consumer discretionary stocks are best positioned for the coming months, based on 4 key factors. Read on to see where the 11 sectors stack up heading into the last half of 2018.

Scorecard: Technology and discretionary remain on top

The S&P 500 has traded in a fairly narrow range through the first half of 2018, gaining 2.6%. Technology, consumer discretionary, and energy top the scorecard, and cyclicals are likely to remain in favor as the corporate profit recovery remains intact. Consumer discretionary had the strongest YTD returns and energy was Q2's top performer, driven by a sharp rise in oil prices. Conversely, real estate and utilities continue to face headwinds.

Fundamentals: Tech, discretionary, materials still strong

Cyclical sectors, led by technology, materials, and consumer discretionary, continued to show fundamental strength through Q2. Technology boasted the highest EBITDA growth and free cash flow (FCF) margin; materials had impressive EPS and EBITDA growth; and consumer discretionary's return on equity (ROE) has been strong. On the other hand, the fundamentals of financials and some defensive sectors, including real estate and utilities, were weaker relative to the broad market.

Relative valuations: Telecom and energy look cheap

Telecom and energy appear inexpensive relative to their historical averages and to other sectors, as both sectors have trailed the broader market over the past few years, despite energy's more recent rally. Financials also looks attractive from a valuation perspective. Conversely, the valuations of technology, consumer discretionary, and industrials appear somewhat elevated.

Relative strength: Tech and discretionary continued to lead

Technology and consumer discretionary continued their steady leadership through the first half of 2018, while energy also outperformed. Defensive sectors such as consumer staples and telecom continued to trail the broader market, with no clear sign of an impending change in trend. Industrials also lagged over the past 6 months, but some leading indicators suggest a constructive outlook for the sector moving forward.

If earnings come through as expected, stocks appear cheap

The conventional wisdom seems to be that valuations are still elevated. But improving earnings estimates have brought the market’s forward P/E ratio below 16, based on earnings projections for 2019. A P/E of 16 on forward 18-month earnings is near the average of the last 80 years and in the cheapest quartile of periods since 1990. This may be bullish for stocks, and for cyclicals in particular, especially if we are in the early stages of profit recovery.

Consumer discretionary appears well positioned for gains

As a cyclical sector, consumer discretionary has historically benefited from profit recoveries. Another positive signal for consumer discretionary can be found in improving wage growth trends, which tend to boost consumer spending power. This constructive consumer backdrop has helped lift the sector's performance, bringing it into the top spot on a YTD return basis. Two key indicators suggest wages will continue to accelerate into 2019.

Two key indicators signal further recovery in corporate profits

Two important indicators of profit growth have recently turned positive: capital spending (capex) and business lending. When combined, they have significantly increased the odds of sustained corporate profit growth. Industrials has particularly benefited from prior capex recoveries. Capex has strengthened recently due in part to acceleration in commercial and industrial lending, supported by healthy bank balance sheets and low default rates.

Capex growth, valuations positive for transportation stocks

Within industrials, the transportation industry group has historically been a major beneficiary of the nascent stages of prior capex recoveries. In addition, transportation stocks are currently trading at low valuations relative to their own history and their profit margins have been in a persistent uptrend—all constructive signals for the industry group moving forward.

Pricing power could lift returns of railroad stocks

As global profits have recovered since 2017, railroad stocks (within the transportation industry group) have gained significant pricing power—a key driver of the industry's performance relative to the broader market. When the industry’s prices have risen at this rate in the past (near the middle of the historical range), railroad stocks have had a high probability of outperforming, outpacing the market the majority of the time.

Can technology stocks continue their run?

Despite concerns about whether technology stocks can continue to outperform, a number of constructive signals bode well for the sector. For example, the sector's current forward P/E ratio is relatively low compared to history and its profit margins have surpassed prior peaks, suggesting a strong backdrop for the sector moving forward.

Tech leadership not outsized compared to prior top sectors

Although technology has led the market for some time, its excess returns over the last 12 months were significantly lower than the average annual outperformance of market-leading sectors dating back to 1962. In fact, the average top-performing sector outpaced the broader market by approximately 20% in a given year, twice the magnitude of technology's 10% lead over the broader market during the past 12 months.

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