Schwab Sector Views: What Volatility and the Yield Curve Are Telling Us

Key Points

  • A spike in volatility has happened multiple times and sectors have tended to have some historically consistent performance.

  • The shape of the yield curve also provides some information that sector investors should pay attention to.

  • History doesn’t necessarily guarantee the future, but investors should consider historical information in their decision-making process.

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.

“Those who cannot remember the past are condemned to repeat it.”—George Santayana

“History never repeats itself, but it rhymes.”—Mark Twain

Those two quotes explain quite well what we believe investors should be doing right now. It has been an incredible past several weeks, with volatility spiking and multiple hundred-plus-point moves intraday in the Dow Jones Industrial Average. It would be a shame not to try to learn what we can from the market swings and take the appropriate investing actions.

Volatility spikes have occurred multiple times

vix

As seen above, volatility spikes have occurred before, and there has tended to be some relatively consistent subsequent sector performance that we can place in our basket of information when trying to make decisions with regard to sectors.

Our friends at Ned Davis Research (NDR) looked back at the last nine volatility spikes (defined as times when the Chicago Board of Exchange (CBOE) Volatility Index (VIX) rose above 35 after having been below 20 previously). What they found was that when “fear” spikes, you would expect areas of the market perceived as more defensive to be attractive to investors during the subsequent month, and that’s exactly what occurred. In the month following a spike in the VIX, health care and consumer staples outperformed in seven of the cases, while utilities outperformed in six.

Again according to NDR, what becomes more interesting, and useful to our tactical calls, which have slightly longer time horizons, is that performance in the following nine months does a virtual turnaround. More-cyclical sectors move to the top of the list, with consumer discretionary outperforming in seven cases and technology outperforming in six, while health care doesn’t fall off much, outperforming in over half the cases. Meanwhile, utilities falls to the bottom of the list, outperforming in only two cases—the fewest of any of the 10 sectors covered during the time period (real estate is too new to be included). We wouldn’t make a decision solely based on this information, and we all know that past performance doesn’t guarantee future results, but history does have a way of influencing the present, so it shouldn’t be ignored.

An even more important item not to ignore that has received a lot of attention in the media as of late is the yield curve. First, a quick primer on the yield curve. Basically it is a graph of a line tracking the interest rates of fixed income securities (Treasuries in this case) across various maturities—from three months to 30 years typically. There is a belief among some that the fixed income market is “smarter” than the equity market (I’m not convinced) so the yield curve can give us a clue as to what’s happening in the economy. A “normal” curve has lower rates at the short end of the curve and higher rates at the longer end—such as we are currently seeing.

The current yield curve looks relatively "normal"

yield

This makes sense, as investors should typically require higher returns for their money to be tied up in an investment for a longer period of time. But when investors get nervous about where the economy is going, things change—they typically become more willing to hide out in longer-term securities, accepting lower returns in the interest of safety—which could result in an inverted curve, which is when rates at the longer end of the curve are lower than they are at the short end. As you can see below, such an occurrence has been an indication of an imminent recession in the past.

An inverted curve often flashes a warning signal

10 year

Obviously, in the lead up to an inversion, the yield curve has to flatten—meaning longer rates and shorter rates get closer together—which could make some investors nervous that a recession is on the horizon. But a flatter yield curve certainly doesn’t always lead to a recession, and investors should be careful about overreacting. Again our friends at NDR looked at instances where the difference between the 30-year Treasury bond and six-month Treasury bill moved below 100 basis points (bps), which is close to where we were a mere one month ago (108 bps per FactSet)—it has since steepened. What they found during the previous flattening periods, until the time the curve inverted, was that energy outperformed 83% of the time, while tech outperformed 67% of the time. On the flip side, both the consumer discretionary and utilities sectors underperformed 83% of the time.

As mentioned, the curve has actually steepened recently, largely due to rising inflation expectations, but we were much flatter only a month ago. Meanwhile, a Federal Reserve that seems set on raising rates—which affects the short end—means the possibility that the curve could flatten again certainly exists, and we want investors to be prepared.

So what’s the bottom line following the action of the last few weeks? History can help us by showing that previous spikes in volatility and flatter yield curves don’t necessarily mean that investors should head for the hills. We are still paying attention to the larger economic fundamentals, which continue to look good to us, but are also comforted in our more cyclical stance that history hasn’t shown that diving into defensives is necessarily a great strategy in the current environment.

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 02/20/2018

Consumer discretionary

Marketperform

07/17/2014

12%

6.00%

Consumer staples

Marketperform

05/07/2015

8%

-4.65%

Energy

Marketperform

11/20/2014

6%

-6.10%

Financials

Outperform

05/07/2015

15%

3.62%

Health care

Outperform

01/26/2017

14%

2.32%

Industrials

Marketperform

01/29/2015

10%

1.00%

Information technology

Outperform

04/29/2010

24%

6.05%

Materials

Marketperform

01/31/2013

3%

-0.39%

Real estate

Underperform

01/26/2017-

3%

-7.75%

Telecom

Underperform

09/12/2013

2%

-4.73%

Utilities

Underperform

05/23/2013

3%

-6.03%

S&P 500®  Index (Large Cap)

 

 

 

1.87%

Source: Schwab Center for Financial Research and Standard and Poor’s as of 01/31/18.

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

  • 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.

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.

Performance may be affected by risks associated with non-diversification, including investments in specific sectors. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

All expressions of opinion are subject to change without notice in reaction to shifting market and 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 strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Chicago Board of Exchange (CBOE) Volatility Index (VIX) is an index which provides a general indication on the expected level of implied volatility in the US market over the next 30 days.

Ned Davis Research (NDR) Sentiment Poll  shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of Morgan Stanley Capital International Inc. (MSCI) 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 is a division of Charles Schwab & Co., Inc.