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Schwab Sector Views: Scaling Back

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
November 12, 2009

These views are appropriate for investors looking for tactical ideas. Market conditions change quickly so we update our views every two weeks.

Editor's Note: Due to Thanksgiving, the next publication will be on December 10, 2009.

We have been advocating a more cyclically oriented tactical investing stance during the past six months on our belief that the economy would improve and risk taking by investors would increase.

And, in fact, we saw the cyclical areas of the market lead the strong rally off of the March lows as investors anticipated the economic rebound that we are currently seeing, and we believe it will continue.

However, as we all know, the market is forward-looking and we strongly believe that the sharp V-shaped rally we’ve seen in 2009 is highly unlikely to repeat itself in the near future. As such, we are now recommending that investors who have profited from the cyclical rally take some profits and move to a more neutral stance as we enter a more subdued market environment.

In order to achieve this more neutral stance, we are moving our outlook on the materials and industrials sectors to neutral from outperform, while also moving consumer staples and telecommunications to neutral, up from underperform.

This will leave us with an outperform view on the information technology sector and an underperform view on the utilities group.

Sectors	Schwab Sector Views	S&P 500 bench- mark weight	Dow Jones Wilshire 5000 bench- mark weight	Date Sector View last changed	Year-to-date return as of
Consumer discretionary
Consumer staples
Energy
Financials
Health care
Industrials
Information technology
Materials
Telecom
Utilities
S&P 500® Index (Large Cap)

Consumer discretionary: Marketperform
The retail front continues to look at least slightly better than many market participants have been expecting, although all is still certainly not rosy in the discretionary space.

October retail sales reports indicated slightly better-than-expected results, while also showing signs of some margin improvements—both positive developments in the space as we enter the critical holiday shopping period.

In fact, with inventories across the retail world at extremely low levels—as retailers don’t want to have to commence massive discounting to get rid of excess inventory as they did in 2008—the surprise this holiday season might be that we will see continued margin improvements and fewer sales than currently expected. In fact, we wouldn't be surprised to see shortages of more items than usual as the season progresses.

Additionally, at the end of a year when American consumers have shown restraint in spending, it is not too difficult to imagine some pent-up demand being released during this time of the year—resulting in the potential for upside surprises. Remember, Americans have a propensity to consume and have defied predictions of their shopping demise many times before.

However, we don't believe that a return to the "good old days" is in the cards. The more likely scenario is that consumers will continue to deleverage their balance sheets.

We continue to see consumer credit contract—seven straight months now, the first time that's occurred since 1991—which means there's less money out there to spend. Combine that with the loss of wealth due to the housing and market performances, and you likely have at least a more constrained, by choice or by force, consumer.

Also, competition in the retail arena remains fierce, and price wars could result in pressure on margins in some cases. Therefore, we remain neutral on the sector and believe that it will largely perform in-line with the market for the foreseeable future.

See our top-rated stocks for the consumer discretionary sector in the Take action box at top right.

Positive factors for the consumer discretionary sector:

Inventories continue to be very lean, which could provide some level of pricing power to retailers.
Housing seems to be stabilizing, which could make consumers more confident in making discretionary purchases.
The stock market has rebounded sharply off of its lows, potentially helping to boost consumer confidence.
Retailers have aggressively cut costs, which should continue to help support profits.
Continuing jobless claims continue to fall, indicating the job outlook could be stabilizing.
Holiday sales are highly correlated with stock market performance leading up to the period, which could bode well for this season.

Negative factors for the consumer discretionary sector:

The unemployment rate is relatively high, and we believe it will move higher, which dampens the outlook for spending.
The savings rate in the United States has been increasing. If Americans sustain the current savings trends, this would continue to result in lower consumer spending.
The credit card delinquency rate continues to move higher.
Revolving credit limits are being reduced, which, by extension, will likely reduce consumers' ability to spend.
Credit standards remain tight, although they are showing signs of easing slightly.

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Consumer staples: Marketperform
As part of our overall sector move to a more neutral stance, we are moving our view on the consumer staples group to marketperform from underperform. We have seen the staples sector stabilize recently as the market’s rally has moved into a more sideways pattern, and we believe this “digestion” is likely to continue for the near future, boding somewhat better for the staples sector.

The consumer staples sector is traditionally defensive in nature and investors who are becoming more nervous about the sustainability of the 2009 rally might look to the group for some protection. As a result, we believe the performance of the sector will be more in line with the market in the near future.

There are certainly still issues with the group as margins remain tight due to fierce competition and largely limited pricing power, but that is being partially offset with cost cuts at the corporate level at many companies in this space. While not overly exciting, we also don’t believe the group is overly depressing and have a balanced view for the time being.

See our top-rated stocks for the consumer staples sector in the Take action box at top right.

Positive factors for the consumer staples sector:

Should the economic recovery begin to stall or retreat, investors would likely return to more defensive sectors such as staples.
Should the market "correct" to a larger-than-expected degree, investors might look for cover in the more defensive areas of the market.
Staples retailers have aggressively cut costs and attempted to create more perceived value for the consumer, which could help to support sales.
Defensive groups could become more attractive after the sharp rally that has left some investors a bit skittish.

Negative factors for the consumer staples sector:

Competition continues to accelerate and is exacerbated by the increasing emergence of Chinese production, which potentially causes pricing power in the group to evaporate as it compresses margins and squeezes earnings.
Pricing power in the group has been declining as of late.
Retail sales of noncyclicals as a percent of total retail sales are moving lower, which has been an indication of underperformance in the past.
Decreasing volatility and increasing risk tolerance tends to hurt defensive sectors such as staples.

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Energy: Marketperform
Energy has been the best performing sector during the past month, as oil prices moved over the $80 per barrel mark. While we like the exposure the energy sector has to international markets, we believe that the recent move is at least a bit overdone and believe at least a modest pullback could be in the offing as some of the speculative money takes some profits.

Crude oil supplies remain relatively high by historic standards, making us a little less than bullish on the energy complex in the near term. Also, global demand forecasts continue to be moved lower as economic growth slowly returns and new efficiency measures gain a foothold.

In addition, oil tanker rates, which can help gauge demand for oil as it's shipped around the world, remain near six-year lows, and don't show many signs of turning up in the near future.

However, those negative aspects are somewhat balanced as we see signs that the global economy is returning to growth, and energy will continue to be a critical component of infrastructure improvements, which are being targeted by governments seeking to boost their economies.

Longer term, we have a more positive outlook for the energy sector. Developing countries will almost certainly continue to demand more fuel and, once economies around the world start to show sustainable growth, we believe that will shore up demand again.

In fact, once we believe the fundamentals more accurately reflect what is occurring within the sector, we will likely look to move the group to an outperform rating.

See our top-rated stocks for the energy sector in the Take action box at top right.

Positive factors for the energy sector:

Global uncertainties could threaten some supplies, exacerbating an already-concerning situation.
Chinese banking officials have implemented expansionary policies, which has helped stem the decelerating growth in the country, although there are increasing signs that they might be starting to pull back on the reins a bit.
The global oil and gas rig count has been falling while the Institute for Supply Management (ISM) new orders/inventory ratio is rising.

Negative factors for the energy sector:

Supplies could increase dramatically with a renewed commitment to exploration and technological improvements. Should oil companies step up efforts to access those supplies, upward pricing pressures could dwindle.
Refining margin growth is now approaching negative territory while light truck sales are falling, which could further dampen demand for refined product.
Crude oil inventories remain relatively high.
Oil tanker rates remain relatively low, which could indicate soft demand for the foreseeable future.

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Financials: Marketperform
We must admit that it's been extremely hard to get a good read on the financial sector during the past several months, as government intervention and Federal Reserve policy intersect with more traditional market forces.

A relatively good third-quarter earnings season from the group did little to clarify the situation for us, although it did help to support our belief that the worst for the group is well behind us.

After the near collapse of large portions of the financial industry, positive signs are now emerging: Institutions are paying back government loans, the housing market seems to be stabilizing to some extent, and the relatively wide interest rate spread (the difference between what institutions borrow at and what they lend at), is helping boost revenues in the space.

In fact, we are seeing some confidence in the industry from regulators as the Fed is slowly letting some of the extraordinary support measures it put in place during the crisis come to an end.

However, there is likely still another downleg to come in the housing market as a new wave of option adjustable-rate mortgages (ARMs) reset and "shadow inventory" comes onto the market while the commercial real estate market is only now starting to go through its retrenchment, which could be severe—both potentially damaging to the financial industry.

Additionally, this group is being targeted by Congress and various regulatory bodies as the one to clamp down on in order to avoid a repeat of the 2008 debacle. These new regulations could limit activity, and the potential for higher profitability, which heightens the risk that we believe infuses this sector.

As a result, we are maintaining our marketperform rating on the sector and will continue to watch activity in the group and adjust our outlook as needed.

See our top-rated stocks for the financials sector in the Take action box at top right.

Positive factors for the financials sector:

The government's and the Fed's actions show they are willing to go to extremes to try to put a floor in under financials.
The high levels of interest rate spreads should help profitability in certain areas of the sector.

Negative factors for the financials sector:

Revolving home equity loans are declining, which has typically been a bad sign for bank profits and stock performance.
Delinquency rates for all consumer loans have spiked recently, which could negatively affect consumer finance companies.
The financial sector moved sharply off of its March lows, fueled to some extent by short covering and speculative money. We believe this support has largely died off, which could result in more muted performance going forward.
New regulations have severely restricted the ability of lenders to offer "exotic" mortgages, cutting back on the volume of business they can do.
Although improved after government action, confidence in the financial sector remains fragile. Concerns over the continuing dismal housing market—combined with increased government regulation—continue to hover over the group.
Regional banks are especially exposed to the commercial mortgage market, which could see increasing weakness in the coming months.
Uncertainty as to how massive government intervention will affect the financial industry going forward could hold performance back for the foreseeable future.

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Health care: Marketperform
Health care continues to be at the center of political debate in Washington, with the outcome of the discussions still far from certain. We do believe that the most damaging scenarios to the health care sector have largely been taken off the table, helping some investor confidence to return to the group.

However, we caution against getting overly enthusiastic toward the group as risks, both political and economic, remain relatively high—thus our continued marketperform rating.

On the positive side of the ledger, the sector should benefit from increasing demand from an aging population. The sector also has solid balance sheets with good cash cushions and nice dividend yields—all things that make it attractive to us.

However, as mentioned above, we are reluctant to increase our rating as we remain concerned about the outcome of the health care legislation working its way through Congress and how it might affect the profitability of various areas of the sector.

Additionally and separate from the reform issue, federal reimbursements could be squeezed even more than they already have as the US government looks for ways to reduce the massive deficit—potentially eroding profitability.

Finally, we believe that the traditionally defensive component of the sector will be less attractive in the near term as investors seek to benefit from the reflation story and move to more aggressive sectors in search of higher returns.

See our top-rated stocks for the health care sector in the Take action box at top right.

Positive factors for the health care sector:

The aging population could provide a boon for the industry as an increasing number of Americans require more extensive drug treatments and medical care.
Americans are increasingly obese, which results in a greater need for medical attention due to the myriad of health issues that coincide with obesity.
The number of drug approvals by the Federal Drug Administration (FDA) is now moving higher. Historically, this type of action has contributed to an increase in pharmaceutical sales.
Balance sheets in the health care sector remain flush with cash, boosting the possibility of an increase in share-enhancing stock buybacks and increased dividend payments while also increasing the possibility of mergers and acquisitions in the space.

Negative factors for the health care sector:

Government regulation will likely increase during the coming years as more seniors demand intervention in order to theoretically lower their out-of-pocket health-care costs. Legislation being discussed in Congress seems likely to pressure the profitability of a variety of industries in the sector.
Nominal consumer spending on prescription drugs has been slowing.
Growth in consumer spending on health insurance has been trending lower recently—potentially putting managed care shares at risk.
Medicare reimbursement rates are likely to fall under the Obama administration, which could hurt pharmaceuticals, HMOs, and managed care companies.

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Industrials: Marketperform
While we believe the global economic recovery will continue to gain steam, we believe that the stocks in the industrial group may be already reflecting that view and believe that performance of the group will largely be in line with the market in the near term as the overall market digests the large gains we’ve seen since March.

Additionally, we are starting to see some foreign central banks look to pull back on some of the massive stimulus efforts, which could slightly dampen the international growth trajectory in the near term.

Having said that, we’re still not negative on the group as both China and the United States, along with many other countries, have targeted improving infrastructure as a major recipient of stimulus funds. While the efficiency and speed that the money gets from the government into the private sector varies greatly among countries, we believe this emphasis will benefit the industrial group.

We also believe that, as a result of tight purse stings in the corporate office during the past year, companies are about at the point where they need to start replacing and updating equipment—potentially benefitting the industrials sector.

However, while the falling dollar has provided a bit of a tailwind to the internationally exposed industrial sector, it is possible that we see at least a near-term stabilization of the dollar. Investors have shunned the safe haven of the dollar as they sought out riskier, higher yielding assets, but that trend could stall should investors become a bit more risk averse as they seek to lock in profits from the recent move.

See our top-rated stocks for the industrials sector in the Take action box at top right.

Positive factors for industrials:

Corporate balance sheets remain relatively cash rich, which could help push management to invest in new, more efficient equipment in order to help offset production losses due to layoffs.
Unfilled orders in the machinery space are relatively high, which could help to support orders going forward.
Lower energy prices compared to year-ago levels could help to support profits and year-over-year earnings comparisons.
Several manufacturing surveys have shown improvement as of late.
Lending standards, while still tight, have started to loosen, which should help to boost capital spending.
New orders of machinery vs. inventories has spiked, which has been a good sign for industrial production in the past.
Inventories in much of the manufacturing area are extremely low, leading to the possibility of a demand-inspired rebuilding phase.

Negative factors for industrials:

Business spending continues to be restrained as executives remain cautious.
Inventories in the aerospace and defense space are growing as orders are increasingly being scaled back or cancelled.
Access to credit, in many cases, remains limited, which dampen spending plans.
The dollar could at least temporarily stabilize or strengthen, which would remove a tailwind that has helped performance to this point in the year.

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Information technology: Outperform
Despite our move to a more neutral overall stance, we continue to believe the technology sector is likely to continue to outperform, although we are growing a bit more cautious as it seems that an increasing number of investors are joining us on the technology train. Despite this, for the time being, we still like the prospects for the group as we head toward the end of the year.

As business confidence builds, it seems likely to us that one of the first places targeted will be the technology arena. These investments are typically attractive because they tend to increase companies' efficiency and productivity at all levels.

As a result, companies can produce more with fewer workers, which allows companies to cut back on costs and potentially expand margins.

In fact, the tech group could get a bit of a tailwind behind it following the recent release of the new Windows® 7 operating system.

Many companies put off upgrading during the previous release as reviews were relatively poor, meaning that a large number of computers are running on software over five years old—an eternity in the tech world. If companies choose to upgrade, they will likely, in many cases, look to upgrade their hardware, as well, leading to a bit of the tailwind described above.

Additionally, technology companies continue to have good cash balances and solid balance sheets which are especially attractive characteristics in this tight credit environment.

See our top-rated stocks for the information technology sector in the Take action box at top right.

Positive factors for information technology:

Growth in business investment in technology is now outpacing the growth in total business investment.
Real tech investment has been below trend for several years, which could bode well for the future of the sector as spending returns to more normal levels.
Retail sales in electronic and appliance stores have been rising rapidly as a percentage of total sales as of late.
We are starting to see banks loosen lending standards, which could slowly help to revive capital investments.

Negative factors for information technology:

Increasing global competition, especially in low labor-cost environments, will likely continue to compress profit margins.
We see signs that companies are continuing to be hesitant to increase capital spending.

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Materials: Marketperform
The materials sector has had a nice run since March and we believe now is the time for investors who have profited from that run to trim positions a bit. Along with our overall sector move to a more neutral sector stance, we are reducing our view on the materials group from outperform to marketperform.

We remain relatively optimistic on the global economic recovery, but also recognize that the stock market is forward-looking and that a lot of that recovery story may already be priced into these stocks. We believe more sideways action is likely as the market continues to digest the gains seen since the March lows, bringing the materials group along with it.

Stimulus measures around the world remain largely in place, but we are starting to see some central banks slowly start to remove some of the more excessive measures, which could dampen return expectations for the internationally exposed materials group.

Additionally, the dollar weakness has helped boost prospects for the materials group, and a stabilization or rebound in the US currency would likely put a bit of a dent in the picture for the materials group.

Finally, the increase in risk tolerance among investors has certainly benefitted the materials group but we believe that trend could pause for a time as traders take stock of how far the market has come since March. While we believe the global recovery will continue, there are still risks out there that some investors may become a bit more cognizant of in the coming months—potentially dampening the return potential for the materials sector.

See our top-rated stocks for the materials sector in the Take action box at top right.

Positive factors for the materials sector:

Scrap steel prices have started to turn higher, which could help to support the materials sector.
The Baltic Freight Index has improved as of late, which bodes well for global demand for materials.
Global government stimulus is reflationary in nature, which could help the materials sector's performance.

Negative factors for the materials sector:

Chinese demand for processed commodities may be slowing as technological advances and a buildout of production facilities allow the country to produce more of its own materials. China recently transitioned from a net importer of steel to a net exporter.
Chemical shipments have had a relatively close correlation with house and auto sales, which, given the recent trend in both, doesn't necessarily bode well for the space.
Some central banks are starting to talk about reining in some of their stimulus measures.
In China, due to the government's rapid and, at times, somewhat hasty response to the global downturn, overcapacity has started to become an issue. For now, aluminum production appears to be the best example of that, although there is a risk that other areas of overcapacity could develop.

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Telecommunications: Marketperform
While telecom still faces challenges, we believe the prospects have improved enough to move our view to marketperform from underperform. This is also in keeping with our move to a more neutral overall sector stance as it seems more likely in the near term for sectors to trade more in tandem than we have seen through much of 2009.

The telecom sector has lost a lot of its traditional defensive appeal, in our opinion, as the group has moved much of its business model from the stable and consistent regulated fixed-line business to the more variable, consumer-dependent wireless arena while also dealing with an onslaught of competition from a variety of sources.

Competition for the increasingly budget-conscious consumer spending dollars continues to be fierce, and telecom has certainly not been immune from bargain-hunting shoppers. However, we are seeing signs that the American consumer may not be as moribund as feared and the holiday shopping season could help to boost spending in the telecom arena.

In contrast to the technology sector, companies in the telecom sector have a large amount of debt on their balance sheets, which causes us to continue to look at this group with caution, but we are seeing credit markets loosen up slightly, which may allow the sector to roll over that debt and continue to invest in their businesses.

See our top-rated stocks for the telecommunications sector in the Take action box at top right.

Positive factors for the telecommunications sector:

Wireless demand appears to be increasing as more communication and media devices move to the wireless arena, although some of that movement is likely to take away from fixed-line revenue.
The holiday shopping season could be better than expected, which may benefit the wireless area of the telecom sector.

Negative factors for the telecommunications sector:

Consumer spending on telecom versus total spending is now falling, which has typically coincided with underperformance for the sector.
Net profit margins are declining for the telecom sector as competition squeezes margins.
Growth in consumer spending on telecom versus total spending is now falling sharply, which has typically coincided with underperformance for the sector.
The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector. That could hurt the group in this tight credit environment.

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Utilities: Underperform
The utilities sector has bounced a bit as of late but we believe it is relatively short-lived, despite our overall sector move to a more neutral stance.

While the overall market could continue to digest recent gains, leading to some marginally better performance in the defensive issues, we continue to believe investors will shun the ultra defensive utilities sector.

With economic recovery continuing to move forward and reflationary policies still in place, retail investors are increasingly looking to add a bit more risk—in hopes of greater returns.

If this trend continues, which we believe it will, the utilities sector would likely continue to underperform relative to other groups.

Additionally, although the sector has had some brief periods of outperformance during the past several months, it appears to be unable to gain any real traction as concerns build that the group may struggle with the slowdown in construction, resulting in slowing demand for new services.

See our top-rated stocks for the utilities sector in the Take action box at top right.

Positive factors for the utilities sector:

Dividend-paying stocks remain attractive as long as yields on conservative fixed income products remain relatively low. Should economic prospects decline further than currently expected, defensive, dividend-paying issues could become more attractive.
After the run in the market since March, a correction may be in order, which could temporarily benefit the defensive utilities group.

Negative factors for the utilities sector:

Utilization rates of electric and gas utilities have moved down modestly while production has spiked—indicating a potential oversupply issue that could pressure margins.
Electricity prices have weakened as a result of dampened demand during the global recession.
Capacity growth has been rising, which has been a sign of underperformance of the sector in the past.

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About Schwab Sector Views
Schwab Sector Views were developed by Charles Schwab & Co., Inc.'s ("Schwab's") Investment Strategy Council. Schwab Sector Views are Schwab's outlook on the 10 broad sectors as classified by the widely recognized Global Industry Classification Standard (GICS) groupings. The GICS structure is comprised of sectors, industry groups, industries and subindustries. Schwab Sector Views are at the sector level. While Schwab Equity Ratings and Schwab Industry Ratings utilize a disciplined approach that evaluates all stocks (Schwab Equity Ratings) or all industries (Schwab Industry Ratings) in the same manner, Schwab Sector Views uses analytical techniques and methods that vary from sector to sector.

Explanation of columns in chart: The benchmark weights are provided for reference and represent each sector's market capitalization weight in its index.

Schwab Sector View represents our current outlook on each particular sector. All investors should be well-diversified across all sectors. However, investors who want to tactically overweight or underweight particular sectors may want to consider our 3–6 month relative performance outlook reflected in this column. These views refer only to the domestic equity portion of investors' portfolios.

How should I use Schwab's Sector Views?
Investors should generally be well-diversified across all sectors, at or near the respective sector market capitalization weights relative to the overall market (benchmark). However, investors who want to make tactical shifts to those weights with a goal of outperforming the overall market can consider the Schwab Sector Views as a resource. Schwab clients can also use the Schwab Stock Screener or the Schwab Mutual Fund Screener to help identify buy and/or sell stock or mutual fund candidates in particular sectors that they may be underweighted or overweighted in their portfolios.

How to use Schwab Sector Views in conjunction with Schwab Equity Ratings
Sector diversification is an important building block in portfolio construction. Schwab Sector Views are expressed in terms of outperform, marketperform and underperform, and can be particularly helpful in evaluating and monitoring your portfolio composition. Schwab Sector Views can be useful in screening new stock purchases and in identifying portfolio holdings for possible sale. A review of sector weights coupled with individual stock concentration should be a critical measure of equity portfolio diversification. Schwab Equity Ratings provide an objective and powerful approach for helping you select and monitor stocks.

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Important Disclosures

The Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. The graph indicates returns based on gross returns. If commissions and other costs are deducted, the performance would be lower.

The GICS was developed by and is the exclusive property of Morgan Stanley Capital International Inc. and Standard & Poor's. GICS is a service mark of MSCI and S&P and has been licensed for use by Charles Schwab & Co., Inc.

The Schwab Center for Financial Research ("SCFR") is a division of Charles Schwab & Co., Inc. The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

For individualized advice, please contact Schwab at 877-284-9817.

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©2009 Charles Schwab & Co., Inc. All rights reserved.

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