Schwab Sector Views: Could 2021 Be Normal?
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2020 was a terrible, horrible, no good, very bad year, to say the least—although it was pretty good for the markets. The COVID-19 pandemic-related shutdowns resulted in a sharp recession and record-fast bear market. The equally quick “V-shaped” rally from the market lows in March 2020—which was spurred by the initial strong boost of monetary and fiscal policy stimulus—was marked by strong mega-cap growth stock leadership. Quite obviously, there was nothing normal about the economy or the markets—either on the way down or the way back up.
As we enter 2021, we think that the economy faces some significant challenges, given that the trajectory of the recovery is slowing. We expect a choppy start to the year, related to a near-term surge in COVID cases and localized shutdowns. However, we expect the economy to regain its footing courtesy of the anticipated distribution of the COVID-19 vaccines and expectations for more fiscal stimulus.
In terms of our market outlook, things have become … well, less abnormal, which we think will continue into 2021. There is heightened risk of a pullback, as investor sentiment has likely become too frothy, but the cyclical backdrop remains positive for equities. The stock market advance has broadened, with a shift toward some of the most beaten-down cyclically oriented industries,1 such as hotels, automobiles, and airlines within Consumer Discretionary and Industrials sectors. However, many pro-cyclical value sectors—such as Financials, Energy and Materials—also are catching up with the high-flying growth stocks. This is more in line with the traditional relative sector returns that we’d expect coming out of a recession (except for Energy), which would include still-solid performance in growth stocks—even if they are not the leaders.
Momentum is favoring more cyclically oriented sectors
Source: Schwab Center for Financial Research (SCFR), Bloomberg. 1-month return period 11/06/2020 to 12/06/2020. Performance since 4/30/2020 ends on 12/06/2020. This is based on our assessment that the “early expansion” period began on or around 4/30/2020 (although the National Bureau of Economic Research has not declared an end to the recession that began in February 2020, we base our assessment on a May rebound in the Conference Board Coincident Composite of 4 Coincident Indicators).
Past performance is no guarantee of future results.
We recently removed our longstanding overweight view on large-cap stocks, as we think small-cap stocks could do well in the more normalized environment. We also think that longer-term interest rates could continue to rise modestly in 2021. Both small-cap outperformance and higher interest rates are historically consistent with outperformance of pro-cyclical value stocks—particularly Financials. Conversely, this could spell trouble for sectors that tend to underperform when rates rise and are defensive2 in nature—like Consumer Staples and Utilities.
While relative valuations are typically more important over the longer term, I think the recent shift in sector leadership could be the start of a rotation toward those sectors with more attractive valuations and strong fundamentals. Financials and Health Care stand out as sectors that have both qualities. You can find more information about our factor analysis in “Schwab Sector Insights: A View on 11 Equity Sectors.” In last month’s article, “Election, Vaccine News Change the Picture,” I provided an overview of the pros, cons and risks for each of our outperform and underperform sector ratings. In this piece, I’ll go into more detail on mega-cap handoff and some key hallmarks of a cyclical shift into value sectors.
The mega-cap handoff
After leading the overall market higher from the March lows and ballooning to nearly 25% of the total market, the five biggest stocks in the S&P 500® Index, often called the Fab Five or FAAMG (Facebook, Apple, Amazon, Microsoft, and Google), recently gave up the leadership to the broader market. As can be seen below, despite the consolidation in the Fab Five, the market pushed to new highs. But it wasn’t just the next five biggest stocks. It was broad-based, with a rotation into the smaller-cap constituents—which the equal-weighted S&P 500 Index implicitly represents by giving all stocks the same influence within the index.
Broad market catches up with the Fab-Five
Source: SCFR, Bloomberg. Data as of 12/6/2020. Fab-Five (FAAMG) Stocks include Facebook, Apple, Amazon, Microsoft, and Google. The indexes are normalized starting at 100 on 3/23/2020 (the year’s market low).
Past performance is no guarantee of future results.
Another way to see the increased participation of the market rally is through the number of stocks within indexes that are trading above their 200-day moving average. Slowly, more stocks that were the worst-hit by the COVID-19 shutdown—including stocks in the Consumer Discretionary, Industrials, Energy and Financials sectors—began to emerge from lows as it became clearer that the monetary and fiscal stimulus was providing businesses access to cash and broad support to the economy as a bridge to this other side of the pandemic crisis. Not only were more stocks in the overall market participating in the rally, but you can see the surge in value stock rising above their 200-day moving average more recently as the rotation to value accelerated, closing the gap with growth stock participation.
Value has closed the gap with growth
Source: SCFR, Bloomberg. Data as of 12/6/2020. The time series represent the percent of index members that are above their 200-day moving average for the S&P 500 Value and Growth Indices.
Past performance is no guarantee of future results.
The business cycle and factors affecting sectors
Equity sector research is an interesting area of the market to study, as sectors are a hybrid of the top-down macro factors and the bottom-up stock-specific characteristics. But as with much of the market, there are no clear lines as to what has the biggest influence—particularly because it’s always a changing picture. That’s one of the things that I love about the markets. One simplistic input into the research process is merely to look at what has happened in the past. For instance, we can look at the previous business cycles and see which sectors outperformed at the different stages.
While each economic cycle is different each time—the cause as well as the path—we tend to see similarities in the equity sector leadership at different stages of the business cycle—early expansion (or recovery), maturing expansion, late expansion and recession. The graphic below provides some generalities about which sectors tend to outperform in the various stages of the business cycle. With the recession now in the rearview mirror and things beginning to normalize somewhat, many of those sectors that have historically outperformed in early stage of the business cycle are currently leading the pack: Information Technology, Consumer Discretionary, and more recently, Financials, Materials and Industrials (Real Estate is lagging).
Sectors and the business cycle
Source: Schwab Center for Financial Research, Bloomberg. Past performance is no guarantee of future results.
But these are based on average returns throughout the business cycles. Each cycle has its exceptions and idiosyncrasies. This latest crisis was obviously much different than the 2008-09 financial crisis. The way various factors affected sectors was different in the 1990s and 2000s than in the past 10 years. That’s where the additional layers of research on the economy, sectors, investor sentiment and individual stocks—particularly the mega-caps—come into play. We can assess different factors through time and try to determine which influences will persist.
As I mentioned above, trends in interest rates, market-cap leadership and value stock characteristics tend to align with how various sectors typically perform. Therefore, we can use our views on those factors as a guide for determining which sectors we think might outperform. We think that in 2021 interest rates will rise, small-cap stocks could outperform (or at least not underperform), and the long underperformance of value stocks could begin to reverse.
In the chart below, you can see that there are higher and lower sensitivities to the change to these factors for each of the sectors. On the left side of the chart, Financials, Energy, Industrials and Materials sectors (all pro-cyclical value) have relatively high positive relationships to all the factors, while the sectors on the right tend to be growth and also pro-cyclical. Intuitively, this makes sense. For example, interest rates typically rise when the economy is humming, a boon to certain interest-rate sensitive sectors3 such as Financials and consistent with underperformance for the typically defensive Utilities and Consumer Staples sectors. In terms of other sectors that historically are hurt by rising rates, they generally carry relatively high levels of debt and pay bigger dividends, which can result in higher interest expense and become less attractive to investors who are seeking yield.
Sector exposure to value, size and interest rates varies
Source: SCFR, Bloomberg. Data as of 11/30/2020. The beta coefficient is the degree of change in the outcome variable for every 1-unit of change in the factor. Factors: Interest rates are the 10-year Treasury Yield; Value vs Growth is the Russell 1000 Growth/Value Index (Bloomberg ticker RU1VGT Index). Small vs Large is the Bloomberg Size Factor Index (Bloomberg ticker PSIZEUS index)
Keep in mind, we don’t solely use these as rationale. They are just some of the things that we consider, but they do provide some confirmation to support other research that helped form our current “outperform” rating on Financials and Health Care and “underperform” ratings on Utilities and Staples.
I hope that you find this useful. With the start of the new year, take this opportunity to review your portfolio allocations. Just as it’s important to make sure your allocations to stocks and bonds are consistent with your target, you should also ensure that your sector exposures within U.S. equities are on target. Schwab clients can sign in and use the Portfolio Checkup tool to check their sector allocations. We provide our opinions on sectors as a guide. If you decide to make any sector tilts in your portfolio, we recommend keeping them small enough to maintain proper diversification.
1 Cyclical sectors tend to see their revenues and earnings go up and down with the economy. These traditionally include Consumer Discretionary, Industrials, Energy, Materials, Real Estate, Financials, Communication Services and Technology.
2 Defensive sectors historically been less influenced by the state of the economy, as their revenues are generally tied to products or services that consumers continue to need in any economy. These sectors traditionally include Health Care, Utilities, and Consumer Staples.
3 Interest-rate-sensitive sectors tend to be influenced either negatively or positively to changes in interest rates. This category traditionally includes Financials (positive relationship), Real Estate, and Utilities (negative relationship).
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
Want to learn more about a specific sector? Visit “Schwab Sector Insights: A View on 11 Equity Sectors” to learn more about each sector and see how they compare. Schwab clients can log in to see our top-rated stocks in each sector.
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. Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations. 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.
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 branch, find a consultant or open an account online.