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Schwab Sector Views: Interested in Some Defense?

By

Brad Sorensen

photo
CFA, Managing Director of Market & Sector Analysis, Schwab Center for Financial Research

Brad Sorensen heads market and sector analysis for the Schwab Center for Financial Research and writes for several Schwab publications. He is a member of Schwab's Investment Strategy Council.

Before joining Schwab in 2004, he was a senior analyst at AMG Guaranty Trust, where he designed portfolio strategies for high-net-worth individuals. Sorensen graduated from the University of Colorado with a bachelor's degree in finance and master's degrees in business administration and finance. He is a Chartered Financial Analyst charterholder.

October 25, 2018

Member for

1 year 3 months
A095922
Submitted by jib.butterworth on Thu, 10/25/2018 - 08:59
Schwab Sector Views

Volatility in the overall market has ramped up recently. Instead of heading for the exits, investors may want to consider adding some defense to their equity positions.

Defensive sectors may not make a lot of forward progress in a down market, but they have tended to lose less, while still providing potential for upside participation and dividends.

The defensive landscape has changed with one sector leaving, and another surprising candidate potentially taking its place.

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.

On the defense

Nervous?

You could hardly be blamed, given the whipsaw action we’ve seen in equities of late, with sharp pullbacks followed by sharp rebounds and more subsequent downward moves.

Volatility has ramped up

Such action may make some investors want to head for the exits, but we continue to recommend that investors hold to their normal allocation in equities, as we are entering a traditionally good seasonal period for equities and we believe the bull market likely has more room to run. But we have advised some de-risking of portfolios, and one way we’ve done that is through our sector recommendations. We’ve recently moved somewhat-more-defensive sectors (utilities and real estate) up from underperform to marketperform, and downgraded a couple of more-cyclical sectors (information technology and financials) to marketperform from outperform.

This leaves us with a modestly defensive stance, with health care our lone outperform rating and communication services our sole underperform rating. We aren’t moving to an even more defensive stance … yet. As mentioned, we believe the bull market has further to run, as end-of-year and post-midterm-election months historically have tended to be good seasonal periods for stocks (according to data provided by Strategas  Research and Ned Davis Research).

However, for those investors who are a little more nervous about the coming months, or have largely ignored defensive sectors up until this point and are underallocated to such groups, we wanted to highlight some areas of the market that have tended to be defensive in nature. These groups allow you to stay invested in the equity markets and participate at least somewhat in a potential up move while providing a bit of a potential buffer against a downturn. There is an acronym that encompasses the defensive group, or at least used to: SHUT. That is, staples, health care, utilities and … well, it used to be telecommunications, but that sector is no more. We’ll get back to the potential T in a minute.

Going back to 1970, there have been 13 bull market peaks (as defined by Ned Davis Research), and while past performance is no guarantee of future performance, in the three months following those peaks, utilities, staples and health care all outperformed the overall market (which lost an average of 9.5% during those periods) at least 69% of the time. Intuitively, this makes sense, as regardless of economic conditions, people are going to continue to need health care services, to turn on their lights and heat, and to buy products such as detergent and toilet paper.

We can also look at the betas of each sector to see how volatile these sectors are compared to the overall market. A beta of greater than one indicates that the sector moves more dramatically than the overall market, while a beta of less than one indicates the opposite. Staples, utilities, health care, along with real estate, are the sectors that have a beta of less than one (Cornerstone Macro).

Additionally, we can look at the correlation with the Index of Leading Economic Indicators (LEI) that each sector has. The SHU sectors all have strong negative correlations with the LEI, meaning that when the LEI moves lower, these sectors generally move in the opposite direction (Cornerstone Macro), as well as moving in the opposite direction of other economic indicators such as the Philly Fed Index.

Health care tends to move opposite Philly Fed Index

Also providing some attractiveness to these groups in a downturn is the potential for cash flow through dividends, especially from the staples and utilities sector, which both have dividend yields above 3% (according to FactSet). Finally, for those who are concerned about the ongoing global trade disputes, focusing a little more on domestic industries may be attractive—and if that’s the case for you, consider that utilities have no reported foreign sales, while staples have less than 25% of their sales from foreign sources (Cornerstone Macro).

But what about the T?

As I’m sure you know, the T in SHUT used to be telecom, but that sector was dissolved and replaced by the communications services sector, which definitely doesn’t start with a T and doesn’t look like a defensive sector to us. But we are seeing a T sector that may be emerging as at least a potential defensive-like sector at times—technology!

Hard to believe, but when looking at the group left behind after multiple stocks with higher volatility moved to the communications sector during the reconfiguration, technology does warrant at least a look. The remaining stocks have a lower price-to-earnings ratio and pay higher dividends, while also having a lower growth rate over the past three years (all according to Cornerstone). Also, the tech sector has large cash balances, according to data from S&P and FactSet as well as Strategas Research, who describes the situation as tech having “hoards of cash.” We’ve already seen the power of that cash through share buybacks (which, according to S&P, set a record in Q2 at up 57% year over year), with tech making up the largest percentage of that number. And with the cash still available, the potential for more buybacks as well as dividend increases exists. The cash also allows the sector to hold relatively low debt levels, should they choose to do so. Muscle memory of investors is hard to change, and we doubt that tech will ever be a full-fledged defensive sector, but it is gaining those characteristics and may warrant at least at small t in the SHUt family.

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 10/23/18

Communications Underperform 09/28/2018 10% N/A*

Consumer discretionary

Marketperform

07/17/2014

10%

9.55%

Consumer staples

Marketperform

05/07/2015

7%

-2.24%

Energy

Marketperform

11/20/2014

6%

-2.22%

Financials

Marketperform

08/16/2018

13%

-6.00%

Health care

Outperform

01/26/2017

15%

10.73%

Industrials

Marketperform

01/29/2015

10%

-4.02%

Information technology

Marketperform

08/16/2018

21%

12.63%

Materials

Marketperform

01/31/2013

2%

-12.65%

Real estate

Marketperform

08/16/2018

3%

-1.57%

Utilities

Marketperform

08/16/2018

3%

5.18%

S&P 500®  Index (Large Cap)

 

 

 

4.09%

Source: Schwab Center for Financial Research and Standard and Poor’s as of 09/28/18.

.*The Communications Sector came into existence on 9/28/18, and the year-to-date information is not comparable to rest of the groups so we are omitting it until the end of the year.

 

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.

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