Sectors to follow in Q2

The markets had a rocky start in 2016, but ended the first quarter with a broad rally. So what sectors are best positioned for the next three months? Heidi Richardson shares her take.

The first quarter of 2016 was a tale of two quarters. In Part I, from the start of the year to February 11, markets plummeted. Oil prices bottomed at $26.21 a barrel, a 13 year low, and the S&P 500 index was at its lowest level in two years. Then in Part II, things turned: Markets rallied broadly and the S&P 500 recovered over 12 percent over the following six weeks.

What’s in store for Q2?

As we head into the second quarter, the big question is: Will we see a repeat of Part 1 or Part 2? And what sectors may be best positioned for the next three months? Here’s a quick look at some of the most notable winners and losers from Q1:

Defensives

The best performing sectors in the first part of Q1 were telecom and utilities, according to Bloomberg. This should come as no surprise, as those so-called defensives historically tend to perform best when the broader market is falling. Then, in Part II, riskier sectors had their moment. Materials, tech and consumer discretionary returned 15 percent or more and financials, industrials and energy were close behind, according to Bloomberg data for Q1. But all 10 sectors showed strong performance, including the defensives.

This is an important point, because the tailwinds for defensives are still in place: Still low interest rates, high uncertainty about the economy’s strength, weakness from abroad, and a relatively strong dollar — even if its relative appreciation has slowed amid dovish commentary from Federal Reserve Chairman Janet Yellen.

Also, share buybacks are at notably high levels. Defensive mainstay consumer staples along with technology (technically not a defensive) has accounted for more than half of the recent buybacks, meaning their prices may be supported. (In other words, prices are presumably supported due to supply-and-demand dynamics. Fewer shares available means people pay more to get them.)

And don’t forget the ingredients for geopolitical risks: The continued uncertainty surrounding the U.S. election, a potential “Brexit” of Britain from the European Union and a possible (albeit unlikely) yuan devaluation in China, just to name a few. Now is a time when quality could be important.

Bottom line: The defensive sectors — telecom, utilities, staples and real estate investment trusts (REITs), have the potential to continue to perform well.

Energy and materials

Both of these sectors rebounded in Part II of the first quarter as oil prices appeared to stabilize — for now. It seems very unlikely these sectors can continue to perform well without a sustained rally in the price of oil, which is very much dependent on reducing the supply glut.

Multiple expansion explains a lot of the gains in the energy sector. In other words, investors were willing to pay more for the same amount of earnings. Remember: You pay for the companies’ earnings, not oil itself when you invest in energy stocks.

Here, the picture seems far worse. At the start of the year, energy earnings were projected to be down 44 percent YoY for Q1. Now, a week before earnings season really starts, and that number now reads a 99 percent decline in earnings. Despite this, the price to equity ratio (P/E) for the sector is up over 7 percent. Energy trades at the highest 12 month forward P/E relative to all other S&P 500 sectors: 51x earnings. The expectations for 2017 earnings growth are at 83 percent, as of Bloomberg Consensus Estimates at the end of Q1.

Bottom line: I’d be cautious about expecting oil prices to double through 2017. Meanwhile, the earnings picture for energy and materials does not look encouraging.

Technology and healthcare

It’s very surprising that two sectors with some of the strongest balance sheets, revenue growth and stable earnings according to Bloomberg data, are the two worst performing sectors year to date. The two sectors are technology and healthcare.

Both were favorites of hedge funds and long-only managers for years, because they led the pack during the period of overall earnings growth for the entire market for Q4 2013 through Q3 2014, according to a 2014 Novus Hedge Fund report. This is still largely true, it should be noted.

However, when sectors become “crowded” they also become prone to unwinds when investors pull their positions, and many areas of tech and healthcare have suffered from this phenomenon recently. It helps explain why so much money has headed into the value corners of the market, like energy and materials, despite their awful earnings pictures.

Bottom line: Over time however, higher earnings typically lead to higher stock prices, so as long as technology and healthcare maintain their track records of revenue growth and headline earnings growth, they could become top performers again. But I would caution that the healthcare sector faces headwinds as we are in an election year and the sector faces increased regulatory scrutiny.

A final note: Whether the second quarter looks more like Part I or Part II of the first quarter, the most sensible approach is diversify — but be selective about where to seek opportunities.

 

Heidi Richardson is Head of Investment Strategy for U.S. iShares and a regular contributor to The Blog.

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