Sector scorecard: Health care has taken the lead

Several sectors scored well in multiple categories in our latest report.

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US stocks steadily crept higher by 1.7% over the past several months, driven primarily by utilities, real estate, and consumer staples stocks. As we head into the final months of 2019, factors like US-China trade talks, Q3 earnings results, and the potential for geopolitical instability have the ability to impact investments across sectors.

If you are looking for new investing ideas, or are reassessing the US stock allocation of your portfolio, this report finds that health care, utilities, real estate, and consumer staples scored more positive than negative marks, based on 4 key factors. Read on to see how the 11 US stock market sectors scored.

Scorecard: Investors favored defense and income in Q3

Stocks posted a modest gain in the third quarter as the Federal Reserve (Fed) cut interest rates twice. Utilities, real estate, and consumer staples led the way as investors emphasized income and defense in the face of lower rates and slowing economic growth. Despite the scorecard’s mixed signals, our sector strategist believes that easing by central banks around the world could help cyclical sectors resume their leadership over the next 12 months.

Fundamentals: Technology, Consumer Discretionary lead

The technology sector ranked first in free-cash-flow margin, second in return on equity, and third in earnings per share growth. Consumer discretionary stocks also fared well in those 3 categories. By contrast, fundamentals were relatively weak in the materials, financials, and utilities sectors.

Relative valuations: Financials, Health Care appear cheap

Financials stock valuations looked low at the end of the third quarter, with an average earnings yield in the top 5% of the sector's 10-year range. The health care sector also screened inexpensive. Consumer discretionary, communications services, and technology stocks looked expensive relative to their historical ranges.

Relative strength: Momentum in Real Estate, Tech, Utilities

A third-quarter surge by real estate and utilities and continued gains by technology helped these sectors take top spots in our relative strength rankings over the past 6 months. Not coincidentally, these 3 sectors' returns led the market during the 9 months through September. Energy, health care, and industrials exhibited weakness relative to the rest of the market.

Manufacturing is down. Could that be good for cyclicals?

Manufacturing tends to be a bellwether for the overall economy, so a recent manufacturing slump has caused some investors to worry about cyclical stocks. Yet cyclicals historically have tended to outperform the market during the 12 months after a manufacturing downturn, with financials and industrials leading the way. The explanation may be that cyclical stocks quickly price in weakness that has already occurred and can benefit from any subsequent rebound.

Declines in new orders aren't necessarily bearish signals

An increase in companies' new orders suggests the economy will strengthen. So investors may find it surprising that stocks have generally fared well even if the ISM New Orders Index has fallen below 50. Stock returns have been especially strong even when a rebound in new orders from a contractionary position hasn't coincided with the economy emerging from a recession. In fact, the S&P 500 has gained in every one of those instances since 1962.

Easing by both the US and Europe has boosted cyclicals

The Fed and the European Central Bank (ECB) are cutting interest rates at the same time. That has happened only about 10% of the time since the ECB's inception in 1998, and when it has, the US market has surged in the subsequent 12 months. Cyclical stocks have fared especially well under these conditions, outperforming the market 71% of the time, while defensive stocks have led the market just 18% of the time.

Global easing often helps counter falling PMIs

Capital purchases have weakened around the world. Soft demand from abroad can affect companies at home—yet US cyclical stocks have tended to perform well after contractions in global purchasing managers' indexes (PMIs). One reason: Weak PMIs often spur central banks to reduce interest rates. And when a growing number of banks ease, PMIs have tended to pick up about 9 months later. The market historically has anticipated that bounce, boosting cyclicals.

Financials' dividend yield may bode well for the sector

The average dividend yield of financials stocks is higher than the yield on the 10-year Treasury—a rare event. In all 12-month periods between 1999 and the present, financials stocks have had about 50/50 odds of outperforming the market. But after their dividend yields exceeded the 10-year Treasury yield, financial stocks have outperformed the market over the next 12 months 88% of the time.

Negative real rates: Good for Industrials?

Real US interest rates—rates after adjusting for inflation—have fallen below zero. Such monetary accommodation has implied a higher likelihood of recovery in capital spending, which has often benefited industrial stocks. Since 1970, industrials have outperformed the market in 84% of the 12-month periods following negative real interest rates. By contrast, the industrials sector beat the market in only about half of all 12-month periods during that time.

Industrials stocks appear cheap

Meanwhile, industrials stocks currently look inexpensive compared to their own history, with both the sector's P/E and enterprise value/sales ratio in the bottom quartile of their historical ranges. In the past, the industrials sector has tended to outperform the market after trading at these low valuations levels.

Next steps to consider

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