Schwab Sector Views: Entering 2017 the Same Way as 2016

Schwab Sector Views is our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is designed for investors looking for tactical ideas. We typically update our views every two weeks, but due to the Christmas holiday, the next edition will be published on Jan. 12, 2017.

It’s hard to believe that another year is winding down … and what a year it has been. But through it all we have—for the first time since I started issuing sector ratings over a decade ago—made no changes to our recommendations during the course of the year. But rest assured, that doesn’t mean we took the year off. In fact, as many of you can attest to, this was one of the toughest years to predict in recent memory. And we aren’t changing our recommendations as we enter 2017 either!

To understand why we believe that’s the appropriate and potentially most profitable course of action, it helps to look back at why we didn’t change throughout the year. The overall call at the sector level entering 2016, and now next year, is that we expect rising interest rates and improved economic performance. As a result, we have an underperform rating on those sectors that benefited most from low interest rates and yield chasing—utilities and telecommunications—and an outperform rating on those that could benefit from better growth and modestly higher rates we rate: financials and technology.

In short, we were a bit early. Those were almost exactly the wrong calls to start 2016, as recession fears moved interest rates lower and investors shifted into more defensive sectors and out of financials, putting us in a pretty big hole to start the year. But as so often in investing, patience is required. We didn’t see a recession in the cards, and thankfully that turned out to be right. Our 2016 calls started to look pretty good until Britain voted on June 23 to leave the EU—the so-called Brexit—which sent investors back into defensive mode and crushed the financial sector. So, a couple of weeks after the vote—at the July 4 holiday—our underperform-rated sectors were leading in year-to-date returns at over 24% each, while tech and financials were at the bottom, both with negative year-to-date performance. Not exactly what we had been expecting!

But then things started to change. The Federal Reserve started talking more about raising rates after the fallout from Brexit turned out to be much milder than some had expected, while economic data continued to show modestly improving growth. Finally, just a month ago, a U.S. election result that shocked the country supercharged our calls, with financials spiking higher, returning over 17% in the month following the election. And over the past three months the financial sector has been far and away the best-performing group, tech has performed roughly in line with the market, while both utilities and telecom are bringing up the rear.

And we don’t think this rotation is over. While there may be some pullbacks from the sharp moves we saw in the weeks after the election, we continue to think that interest rates will move higher, while economic growth improves. While some of investors' hoped-for governmental and regulatory changes may turn out to be wishful thinking, we believe many of them will come to fruition, given the one-party control in Washington. For financials, the regulatory environment seems sure to improve, with both President-elect Donald Trump and his nominee for Treasury secretary, Steven Mnuchin, noting they'd like to see a revamped regulatory system and hope to revise the much-derided Dodd-Frank Act. While it may be difficult to repeal the law, many of its regulations are still in the process of being written, and could be adjusted by a new team in Washington.

Additionally, the interest rate environment continues to improve. We assume the Fed will hike rates again at their December 13-14 meeting, and may hike two to three more times in 2017. As important, in our view, is the steepening of the yield curve in recent weeks. The combination of these two should allow banks to make more money on loans as well as on cash balances being held on their balance sheets.

Interest rate picture should bolster financials


And it doesn’t appear to us that the recent run in the financial sector has caused any sort of valuation problems, as the group had been beaten down for so long. In fact, according to Ned Davis Research, the forward price-to-earnings (P/E) ratio for the financial sector is just now getting roughly in line with its historical average, and we believe there’s a decent chance that earnings projections for the group will be rising in the near future.

The tech sector actually got hit following the election, potentially on concerns about protectionist rhetoric and the stronger dollar hurting this heavily foreign-involved group's earnings. However, we think fears of damaging protectionism are a bit overblown, as some of the campaign rhetoric is already being toned down. And as far as dollar concerns, technology has actually outperformed in five of the eight defined "strong-dollar" periods over the past 25 years, according to data compiled by Strategas Research. That includes the latest strong-dollar  period, from June 2014 to November 2015, when tech had an annualized gain of 13.4%—compared with a 6.5% gain for the broad S&P 500® Index. This gives us some confidence that tech can outperform in a rising-dollar environment, especially if the dollar is rising due to U.S. strength and improving economic prospects (instead of due to investors fearfully hiding in the dollar during times of global economic weakness).

Additionally, we are encouraged that CEO confidence in future business conditions spiked nearly 11% following the election, according to research by Chief Executive Group published on its website, ChiefExecutive.net. That confidence could help to support an increase in capital expenditures that would likely help the tech sector.

And while we certainly don’t know what the results of the desire to reform the corporate tax structure will ultimately look like, we do believe a lowering of the rate to bring to the U.S. cash currently held overseas will occur in some form, providing additional juice for investment. For context, according to Strategas, during the 2005 tax repatriation holiday there was roughly $600 billion being held overseas, and $300 billion of that was brought to the U.S. We don’t know that the ratios would be the same, or even that reform will occur, but the potential is much greater today—in S&P 500 companies alone, there is roughly $2.4 trillion being held overseas. Combine improving CEO confidence and potential additional firepower with a recent increase in the Conference Board Consumer Confidence Index® to 107.1, the highest level since July 2007, and we believe the picture for tech is looking pretty good.

So there it is—why we’re entering 2017 the same way we entered 2016. A rare occurrence and one that seems unlikely to be repeated, but we can’t look too much in the rear-view mirror and definitely can’t change decisions from the past. As we look forward, we believe these calls give investors currently looking to make some tactical adjustments the best opportunity to for potential outperformance.

Schwab Sector Views: Our current outlook

Sector

Schwab Sector View

Date of last change to Schwab Sector View

Share of the
S&P 500 Index

Year-to-date total return as of 12/06/2016

Consumer discretionary

Marketperform

07/17/2014

12%

6.87%

Consumer staples

Marketperform

05/07/2015

9%

2.57%

Energy

Marketperform

11/20/2014

7%

26.28%

Financials

Outperform

05/07/2015

15%

21.57%

Health care

Marketperform

12/13/2012

14%

-3.75%

Industrials

Marketperform

01/29/2015

10%

19.27%

Information technology

Outperform

04/29/2010

21%

11.36%

Materials

Marketperform

01/31/2013

3%

17.65%

Real estate

Marketperform

09/01/2016

3%

-3.03%

Telecom

Underperform

09/12/2013

3%

15.83%

Utilities

Underperform

05/23/2013

3%

10.80%

S&P 500®  Index (Large Cap)

 

 

 

10.48%

Source: Schwab Center for Financial Research and Standard and Poor's as of 11/30/2016.

Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations.

What is Schwab Sector Views?

Schwab Sector Views is our three- to six-month outlook for 11 stock market sectors, which are based on the 11 broad sectors of the economy.

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

  • Outperform: Likely to perform better than the rest of the market.
  • Underperform: Likely to perform worse than the rest of the market.
  • Marketperform: Likely to track the broad market.

How should I use Schwab Sector Views?

Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor's 500 allocations to each sector, listed in the chart above, as a guideline.

Investors who want to make tactical shifts in their portfolio can use Schwab Sector Views' outperform, underperform and marketperform ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.

Schwab Sector Views can also be useful in identifying stocks by sector for potential purchase or sale. When it's time to make adjustments, Schwab clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide an objective and powerful approach for helping you select and monitor stocks. 

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:
-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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