Schwab Sector Views: From the Top Down

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.

In this space, we often zero in on individual sectors or industries by looking at them from a “bottom up” perspective. By that we mean, focusing on fundamental factors such as industry-specific order trends or changes to the regulatory environment in a bid to determine whether a given sector may outperform or underperform the market.

However, “top-down” issues, such as the state of the economy, large-scale political or geopolitical change, or the interest rate environment (as discussed below), can also have a major impact on performance. The problem, according to quantitative analysts I’ve spoken with, is that it’s not always possible to say which type of factor—bottom up or top down—is driving the performance of particular sectors during particular periods. Conditions change, and the predominance of one kind of factor could give way to another type.

So, what’s an investor to do?

First, stay diversified. We provide sector recommendations for investors who want to temporarily seek out or avoid sectors that look set to either potentially outperform or underperform the market—but such investments should result in only modest tactical changes to your portfolio, not a complete shift. We believe it’s important to keep exposure to each of the 11 sectors within a reasonable range—i.e., a few percentage points—of the market weighting. As you can see, the returns of the sectors can vary greatly from year to year, so it could be risky to be excessively over- or underexposed to any particular sector.

Sector returns can vary greatly from year to year

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Sector performance is represented by total annual returns of the following 11 GICS sector indices: Consumer Discretionary Sector, Consumer Staples Sector, Energy Sector, Financials Sector, Health Care Sector, Industrials Sector, Information Technology Sector, Materials Sector, Real Estate Sector, Telecommunication Services Sector, and Utilities Sector. Returns of the broad market are represented by the S&P 500® Index. Returns assume reinvestment of dividends and interest. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. See disclosure pages for more information on indices. Past performance is no indication of future results. (* YTD return as of March 2017).

Second, when we are working to project what sector performance may be over the next three-to-six months we pay attention to both the top and bottom sides of the equation. As noted above, certain factors can have a greater impact on a given sector during some periods than in others.

One thing to note, though, is that over time the investment community has noticed that certain sectors tend to perform certain ways during certain points in the business cycle. For example, defensive sectors, such as consumer staples and utilities, typically perform better when the economy is struggling. This makes intuitive sense because people generally continue to pay their electric bills and buy toilet paper and toothpaste no matter what the economy is doing.

At the other end of the spectrum, we have traditional cyclical sectors such as energy and consumer discretionary, which tend to benefit from a bump in spending on things like travel, meals out and big-ticket purchases for the home when the economy is doing better.

Of course, these are general trends and certainly not hard and fast rules. Exceptions do arise. For example, economic data from around the world suggest the economy is in growth mode, yet energy, which might be expected to benefit from increased demand for the fuels that power growth, is the worst-performing sector so far this year. We believe this is largely due to specific energy-related issues, such as the increase in the domestic supply, that are making the sector break with its historic norm for this point in the economic cycle.

Sectors have generally followed the business cycle

Source: Schwab Center for Financial Research. This chart is an illustration of a typical business cycle only. This is not always a chronological progression in this order. It is not intended to represent the past or future performance of any specific sector.

Our current sector recommendations reflect our belief that the business cycle is currently in a mature phase that would typically benefit later cyclical sectors, with some modest defensiveness tossed in, because the economy seems to be having trouble accelerating.

Certainly, in our view, one of the major top-down factors affecting the various sectors has been the interest rate environment.

Yields continue to impact sector performance

Source: FactSet, Federal Reserve. As of June 20, 2017. Past performance is no indication of future results.

The performance of the utilities sector helps tell the story. This typically “boring” sector has been quite active over the past several years. Why? The utilities sector has traditionally paid higher dividends than some other sectors, which made it an attractive target for yield-seeking investors fleeing the depressed yields in the bond market after years of low interest rates. (We generally urge investors to avoid making major shifts in asset allocation like this, as equities have traditionally been riskier than bonds.)

We are watching both yields and the yield curve—the difference in rates between short- and longer-term bonds—closely. After steepening slightly and moving generally higher, yields have retreated again, while the yield curve has flattened. This has pushed the utilities sector higher and weighed on the financial sector, which runs counter to our current calls.

We continue to believe that longer-term rates should trend higher, hurting utilities and benefitting financials, but we are watching developments closely, as this top-down factor could overwhelm bottom-up factors and push us to make changes in our ratings. For now we are staying pat, with the belief that a tight labor market will push inflation higher, resulting in higher yields, but we aren’t going to be stubborn and will move if the trend doesn’t go the way we think.

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 06/20/2017

Consumer discretionary

Marketperform

07/17/2014

13%

11.03%

Consumer staples

Marketperform

05/07/2015

9%

10.18%

Energy

Marketperform

11/20/2014

6%

-12.31%

Financials

Outperform

05/07/2015

14%

5.44%

Health care

Outperform

01/26/2017

14%

15.33%

Industrials

Marketperform

01/29/2015

10%

10.00%

Information technology

Outperform

04/29/2010

23%

19.04%

Materials

Marketperform

01/31/2013

3%

9.94%

Real estate

Underperform

01/26/2017-

3%

7.08%

Telecom

Underperform

09/12/2013

2%

-8.38%

Utilities

Underperform

05/23/2013

3%

12.92%

S&P 500®  Index (Large Cap)

 

 

 

9.91%

Source: Schwab Center for Financial Research and Standard and Poor’s as of 5/31/17.

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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