The market environment has been shifting for investors. Earnings growth for U.S. stocks has declined, after strengthening for years, the dollar rally has taken a breather, and oil prices have recovered from multiyear lows, but are still a fraction of the price 18 months ago.
Investors who are wondering what these trends may mean for the market may want to look back at history. While history is no guarantee for future performance, it may offer some important clues.
Fidelity’s Denise Chisholm is a sector strategist. Viewpoints caught up with her to discuss the importance of sectors and how sectors have historically reacted during earnings recessions, fluctuations in the strength of the dollar, and during market downturns.
Why are equity sectors an important consideration?
Chisholm: Investors typically focus on style (meaning value or growth), or market capitalization—large cap, small cap, and mid cap when building a portfolio. Sector diversification is sometimes overlooked. But sectors have been an important driver of returns, so understanding sector exposures is an important part of building a portfolio.
Historically, 22% of a portfolio’s performance is driven by sector factors compared to only 4% for market capitalization and 13% for style. Although most investors build portfolios around the style box, sectors have been a bigger driver of returns, and therefore may be an effective building block.
How can history give us insight into sector performance?
Chisholm: I believe history offers valuable insights into sectors. When you examine the probabilities of performance associated with key macroeconomic and fundamental variables, sector performance patterns often become evident. Here’s an example: When the price of oil fell by more than 30 percent last year, many thought that would provide a stimulus to the U.S. consumer and subsequently give a boost to the economy.
Many market participants thought it would result in a pro-cyclical bias—where cyclical sectors would outperform more defensive sectors. However, when you look back through history, in the nine months that follow significant oil price declines, cyclical sectors on average underperform. Of course, averages don’t tell the whole story; in any individual instance results may vary significantly. But what has happened in 2015 is almost right in line with what happened on average since 1970. This is an example of how history can be a great guide to sector investing—of course, the averages don’t always apply and history is no guarantee of future results.
What key themes are you watching this year?
Chisolm: I think there are three big market themes so far in 2016—profit contraction, the U.S. dollar, and downside protection.
First, the issue at the forefront—"profitability problems." Earnings growth on a median basis is contracting. And this is not just an energy phenomenon; seven out of the ten sectors have a median stock with declining earnings. Historically, during times of profitability problems, the defensive sectors of consumer staples, health care, and utilities have most often outperformed. People tend to buy toothpaste, go to the doctor, and turn the lights on regardless of economic conditions. On the other hand, the technology, industrials, and financials sectors are more cyclical. History suggests they tend to struggle in this type of market environment because their earnings tend to rely on discretionary purchases that can change with economic conditions.
A related theme is currency. What we've seen over the past two years is an appreciation in the dollar. This is important, because this is one of the reasons for the profit deterioration we just discussed. Using history as a guide, there have been performance patterns associated with both strengthening and weakening outlooks on the dollar.
Historically, when the dollar is growing stronger at an accelerating rate, domestically oriented sectors such as consumer discretionary, financials, telecom, consumer staples, and health care have had the highest rate of outperformance among any of the sectors based on rolling one-year relative returns since 1975. Alternatively, when the dollar has depreciated, history shows that the globally exposed sectors of materials, technology, and energy have had the highest rates of outperformance.
Finally, given the market volatility we've seen, investors may want a more evergreen strategy, which retains stock exposure, but limits downside risk. History suggests that a diversified portfolio with increased exposure to consumer staples, health care, telecom, and utilities sectors have historically provided lower volatility and loss potential than a sector neutral approach.
Russell 3000® Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the U.S. equity market.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917