Which stock market sectors will outperform over the next few years


*Take my discretionary thoughts with a grain of salt. It’s extremely hard to consistently predict which sectors will outperform/underperform. That’s why I only invest in UPRO, the S&P 500’s ETF. I don’t pick stocks or sectors in my medium-long term portfolio.
The S&P 500 can be broken down into 10 sectors:

  1. Consumer discretionary
  2. Consumer staples
  3. Energy
  4. Financials
  5. Health care
  6. Industrials
  7. Materials
  8. Real estate
  9. Technology
  10. Utilities

I think the finance, energy, and tech sectors will lead the U.S. stock market in the final 2-3 years of this bull market. Here’s why.

Finance

  1. The S&P has vastly exceeded its 2007 high.
  2. The financial sector has merely approached its 2007 high! Here’s XLF, the finance sector ETF.


The finance sector has lagged the S&P 500 for several reasons.

  1. Financial stocks bore the brunt of the Great Recession and market crash. Hence, they started from a much lower point than the S&P 500 in March 2009.
  2. The Federal Reserve’s unprecedented easy money policy has depressed long term interest rates. This hurt financial profits. Rising interest rates = expanding profit margins, and falling interest rates = shrinking profit margins (for banks). Banks have massive cash holdings. They can lend this cash at higher yields when interest rates rise.
  3. Trading revenues and volumes are down because volatility is down. The S&P 500 saw record-low volatility in 2017.
  4. Mergers & acquisitions have not risen significantly as they have in past bull markets.

The first bearish factor has disappeared. Banks have completely recovered, and are much healthier than they were pre-2007.
Interest rates are on the rise. Once the 10 year yield breaks above 3%, there will be no looking back. This will be a boon to banks’ profits, which will cause the financial sector to outperform. Stock prices and earnings move in sync over the long run.

The stock market’s volatility will rise in 2018. Commodity prices are also in a bull market, which means that trading revenues via commodities should rise as well.
The Republican tax cut will be a boon to mergers and acquisitions. (Banks make a lot of money from M&A fees). Here’s the number and value of M&A deals in the U.S. right now. Notice how the value of deals fell in 2017.

In addition, the finance sector has one of the lowest P/E ratios. This is attractive to long term investors.

Energy

Energy sector earnings are rising because the year-over-year change in oil prices is increasing. This is a medium-long term bullish factor for the energy sector.

I expect the energy sector to lead the S&P 500 over the next 2 years. Oil will prices will rise because commodities are in a bull market and the U.S. dollar is in a bear market.
The energy sector is still far below its 2013 high despite its recent overbought rally. (Meanwhile, the S&P 500 has far exceeded its 2013 high.) I expect an oil correction within the next few months, which will bring the energy sector down. But overall, mean reversion states that the energy sector will outperform in 2018 and 2019.
Here’s XLE (energy sector ETF) on a monthly bar chat.

Tech

Some tech stocks are insanely overvalued. There’s no doubt about that. But as a sector, tech isn’t overvalued compared to the broad S&P 500. Tech valuations today are much lower than they were during the dot-com bubble.

More importantly, tech is leading the S&P 500’s earnings growth. Tech companies are crushing it.

  1. The tech sector has the highest percentage of companies reporting above average earnings growth (83%).
  2. The tech industry is taking over other industries. Technology is starting to disrupt everything, including traditional industries like automobiles and farming. Incumbents in these industries are often slow to adapt to change, which gives fast moving tech companies an edge. Think of Amazon killing retailers.
  3. Tech companies are much more exposed to ex-U.S. economic forces than other sectors (the vast majority of their earnings and revenues come from overseas). Foreign economies are surging after a multi-year slump, so the tech sector stands to benefit the most.

Generally speaking, investors won’t stop buying a stock just because it’s overvalued. On the contrary, investors love stocks that are overvalued as long as:

  1. The company/sector continues to experience earnings rapid growth, and…
  2. The broad U.S. stock market is in a bull market.

Tech earnings will continue to surge in the next 2 years as tech companies disrupt more industries. More importantly, our Medium-Long Term Model states that the current bull market still has 2-3 years. As long as the bull market isn’t over, overvalued tech stocks will simply become more overvalued. Investors will keep chasing high momentum stocks in tech simply because these are the strongest “growth” stocks.
In a bull market, the leading sector usually continues to lead until its earnings momentum slows down. Here’s XLK, the tech sector ETF. Notice how XLK has led the S&P 500’s rally.

3 comments add yours

  1. I thought there was 11 sectors in the s&p? Also, is it possible for the tech sector to reach the same 1999 valuations as a double top in terms of valuations even without the fast flying .com stocks that mostly went bankrupt and not in existence?

    • There used to be 11 sectors, but then they turned that into 11. However, the key SPDR ETF’s still base it on the original 10 sectors.

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