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Schwab Sector Views: New Sector Ratings for the New Year

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 month. 

Listen to the latest audio Schwab Sector Views.

 

As we move into 2020, we’re updating several of our sector views. Many of the changes are based on improvement in the macroeconomic environment, new trends in the relative value and fundamental factors for the equity sectors, and some rotation in the sector performance leadership over the last several months. 

Typically, we focus on one topic or sector in this article. This time, we’re writing about each of the sectors on which we have changed our view. We’ll start with a brief overview of the macroeconomic environment, as that sets the context for some of the changes. Please visit the individual sector articles for more information on each of the 11 sectors.

Macro environment:  Rising stocks and Treasury yields, fading U.S. dollar

We continue to see a gap between the health of the manufacturing sector and that of the services sector and consumers. Despite recent U.S.-China trade war de-escalation, manufacturing activity remains under strain from ongoing tariffs, new tariff threats and still-elevated trade policy uncertainty, combined with slow global growth. On the other hand, the services sector continues to thrive amid strong consumer confidence and consumption, in large part due to a strong job market. 

While economic momentum overall has slowed, we do see signs of stabilization in both the United States and abroad. Accommodative monetary (central bank) and fiscal (tax cuts and government spending) policies have provided a strong tailwind for the global economy. The signing of a “phase-one” trade deal between the U.S. and China, combined with congressional passage of the new U.S.-Mexico-Canada (USMCA) trade pact, have eased some trade uncertainty. Amid this apparent global economic revitalization and shrinking trade risk, Treasury bond yields have risen, the value of U.S. dollar has declined and U.S. stocks have advanced to record highs.

However, geopolitical risks—while reduced somewhat—remain elevated, and equity valuations are high. Given this combination, we think bouts of increased volatility and more frequent pullbacks are possible. This doesn’t necessarily mean the rally won’t keep going—it’s likely the strong momentum in stocks may continue until there is a catalyst sufficient to deflate the current extremely bullish investor sentiment—but the risks need to be considered.

This sets the stage for our updated sector views, shown in the table below. 

Note: Each of the sector lenses shown above—Macroeconomic, Value, Fundamental and Relative Strength—is both intuitive and evidenced-based in nature. Within each, there are a varying number of factors. The Macroeconomic lens includes sector sensitivities to interest rates, stocks and the value of the U.S. dollar; the outlook for each of these is determined by the Schwab Center for Financial Research (SCFR)’s Asset Allocation Working Group, which uses a mosaic approach of quantitative and qualitative considerations. Value includes six different valuation metrics that provide a holistic perspective on current valuations relative to each of the sectors’ own historical valuations, as well as relative to the other sectors. Fundamental provides insight as to how efficiently the companies within each sector use invested capital to produce earnings; this historically has been informative as to future relative performance of the sectors. Finally, Relative Strength measures momentum of the individual sectors against all of the other sectors. We also consider the data in the context of factors outside the scope of these indicators—for example, geopolitical risk or anticipated tax legislation.   

Source: Charles Schwab, as of 01/23/2020.

Communication Services: Marketperform

The Communication Services sector is concentrated in a handful of cutting-edge companies with which nearly all Americans have contact on a daily basis—including search engine and social media companies, streaming services and wireless telecommunications companies. 
While these companies enjoy significant competitive advantages due to their dominance in their respective business lines, there are also emerging antitrust risks. The rollout of fifth-generation (5G) cellular wireless technology could increase demand, as 5G is expected to increase speeds and allow for more exposure to the “Internet of Things” and automated car technologies—increasing growth potential. However, upgrading networks will require substantial capital investment.

There is clearly a confluence of positives and negatives to consider from a qualitative perspective. When we assess the pros and cons through a more quantitative lens, we have a similarly mixed picture. The sector tends to trade right in line with the overall markets, so any insight we have on the overall market offers little. In terms of relative valuations, the few individual companies that compose more than 50% of the sector are difficult to assess. And the current Communication Services sector was launched in 2018—it replaced the narrower Telecommunication Services sector—so a comparison against the sector’s own history is not practical. We can compare some of the fundamentals—such as return on equity—with other sectors, and they are in the middle of the pack.

Communication Services’ return on equity is average vs. other sectors

Chart 2 Comm Services ROE

Source: SCFR, using data from Bloomberg, as of 1/15/2020. Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity.  Past performance is no guarantee of future results.

We believe that many Communication Services companies face unique risks, but their strong competitive advantages within the industry also afford them potential rewards. The balance of the evidence is neutral, in our view.

Financials: Outperform

We believe the Financials sector will benefit from interest rate trends—while the Federal Reserve is expected to keep short-term rates low for now, improving economic conditions should contribute to rising longer-term Treasury yields. Typically when the yield curve steepens—that is, when longer-term yields rise higher relative to short-term yields—it’s helpful for financial institutions, which generally borrow at short-term rates and lend at longer-term rates. 

The Financials sector is highly sensitive to interest rates

Chart 3 Financials sensitivity to interest rates

Source: SCFR, using Bloomberg data, as of 1/15/2020. 
Interest rate sensitivity is based on 3-year beta to 10-year Treasury yield. The beta (or beta coefficient) of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1.

Also, relatively attractive valuations may provide some additional support. 

Valuations in the Financials sector are relatively low

Chart 4 Financials valuation composites

Source: SCFR, using Bloomberg data, as of 1/15/2020. 
These valuation composites measure the number of standard deviation of up to six valuation metrics—eg, price/earnings (P/E) ratio, price/dividends, price/book, price/cash flow, price/sales and price/forward earnings estimates—above (below) their 15-year medians. Note that not all metrics are appropriate for all sectors; for example, in the Real Estate sector, REITs do not generate earnings (most or all of net income is passed through to investors) so price/funds from operations (P/FFO) is used instead. Above (or below) zero denotes higher (or lower) than historical median valuation. A standard deviation is a unit of measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean of the set, while a high standard deviation indicates that the values are spread out over a wider range. This chart reflects the number of standard deviations above (below) the long-term median of the S&P 500 Index and the respective sectors.

Current fundamentals are in the middle of the pack, as revenue growth is expected by the market to be tepid in 2020. However, the recent slowdown in loan demand growth is likely to reverse with stabilization in economic growth, and could improve with a renewed acceleration in the economy. We may already be seeing early signs of that, as forward earnings estimate revisions have begun to move higher. 

In terms of risk to our outlook, topline revenue growth may prove to be elusive as regulatory burdens remain high, and areas like asset management and brokerage services suffer from severe price competition and low short-term interest rates. Additionally, the sector’s sensitivity to interest rates and the stock market could translate into sharp underperformance should we see a significant pullback in the market. 

Materials: Underweight

The Materials sector has been sensitive to fluctuations in the global economy, as well as concerns about the U.S.-China trading relationship. Although accommodative monetary and fiscal policies have boosted global economic growth, and recent trade agreements have eased some of the trade uncertainty, the sector still faces significant challenges. 

For example, still-tepid global growth is not expected to provide an enduring tailwind to industrial metals or demand for chemicals. Relative valuations and fundamentals remain poor. While revenue growth is expected to recover from a deep drawdown in 2019, only modest growth is expected over the next two years. 

Earnings are expected to recover and grow moderately, boosting profit margins—however, wage costs are rising in the Materials sector, as we've seen skilled-labor shortages in certain segments of the market. Finally, relative strength in sector performance—both shorter and longer term—has dramatically lagged the broader market and other sectors, and we don’t see a catalyst to change this. 

As a result, for now, we have an underperform view on the materials sector.

Utilities has the least sensitivity to equities

Chart 5 Utility equities sensitivity

Source: SCFR, using Bloomberg data, as of 1/15/2020.

Utilities: Underweight

The Utilities sector has tended to perform better when growth and trade concerns resurface, and to underperform when those concerns fade. That’s partly because of the sector’s traditional defensive nature—people need water, gas and electric services during all phases of the business cycle—and because it has very little international exposure. That suggests that signs of improvement in the global economy and easing of trade concerns could be a drag on the sector.

Meanwhile, Utilities stocks are among the most negatively affected by rising interest rates. The sector has high fixed costs and relatively high debt ratios, which could become problematic if there is any faltering of demand, or higher interest rates. The sector has experienced poor momentum relative to the other sectors—both on a short- and long-term basis—which could continue if longer-term interest rates continue to trend higher, as we expect they will. 

While defensiveness can be attractive in uncertain times, we are increasingly concerned about valuations, which have risen to well above historical levels both on an absolute basis and relative to the other sectors. 

Bottom line, we have a underperform rating on the Utilities sector.

A final word

Keep in mind that no matter what our view is on any of the sectors, remaining diversified is very important. Concentrating in too few sectors can dramatically affect the risk profile and performance of your portfolio. So if you do make any sector tilts in your portfolio, keeping them small is a good way to maintain appropriate diversification and potentially enhance the performance of your portfolio.


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 01/22/2020

Communication Services Marketperform 01/23/2020 10.4% 5.43%

Consumer Discretionary

Marketperform

07/17/2014

9.8%

1.82%

Consumer Staples

Marketperform

05/07/2015

7.2%

1.86%

Energy

Marketperform

11/20/2014

4.3%

-3.51%

Financials

Outperform

01/23/2020

13.0%

0.04%

Health Care

Outperform

01/26/2017

14.2%

2.62%

Industrials

Marketperform

01/29/2015

9.1%

2.45%

Information Technology

Marketperform

08/16/2018

23.2%

5.84%

Materials

Underperform

01/23/2020

2.7%

-1.54%

Real Estate

Marketperform

08/16/2018

2.9%

3.36%

Utilities

Underperform

01/23/2020

3.3%

4.14%

S&P 500  index 

 

 

 

2.87%

 

Source: Schwab Center for Financial Research, FactSet (for YTD total returns) and S&P Dow Jones Indices (for S&P 500 sector weightings). Sector performance data is based on total return for each S&P 500 sector subindex (see “Important Disclosures” for index definitions). Sector weighting data is as of 12/31/2019; data is rounded to the nearest tenth of a percent, so the aggregate weights for the index may not equal 100%.

Past performance is no guarantee of future results.

 

What do the ratings mean?

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 broader stock market* 
  • Underperform: likely to perform worse than the broader stock market
  • Marketperform: likely to track the broader stock market

 

*As represented by the S&P 500 index

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® Index allocations to each sector, listed in the chart above, as a guideline.

Investors who want to make tactical shifts in their portfolios 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. Schwab clients can use the Portfolio Checkup tool to help them review and manage their sector allocations. When it's time to make adjustments, 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.

What you can do next

  • Review your sector allocation. If you aren’t sure how to analyze your sector weightings, a Schwab Financial Consultant can help. 
  • Explore our views on individual sectors in Sector Views.
  • Talk to us about the services that are right for you. Call us at 800-355-2162, visit a branchfind a consultant or open an account online.
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Real Estate Sector Rating: Marketperform

Important Disclosures:

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. Supporting documentation for any claims or statistical information is available upon request.

All expressions of opinion are subject to change without notice in reaction to shifting market or other conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and asset allocation do not ensure a profit and do not protect against losses in declining markets. 

Market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

The Schwab Center for Financial Research (SCFR) is a division of Charles Schwab & Co., Inc.

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