Sectors That Could Capture Gains This Year

The exponential rebound in the stock market after the lows in March due to the coronavirus pandemic remains a concern for market strategists who caution investors to be wary about rapid turnarounds in some key sectors.

The energy, financial and industrial sectors performed the worst during the pandemic decline with respective losses of 56%, 43% and 42%. Other sectors such as real estate and materials lost nearly as much and dipped by 38% and 36%, respectively, according to Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional.

While it remains unknown how U.S. trade tensions with China, the American presidential election and the longer-lasting impact of the pandemic will affect both small and large businesses, investors should consider reallocating a portion of their assets.

Choosing stocks over bonds and also overweighting cyclicals over defensives, small-cap stocks over large-caps and low-quality over high-quality stocks is one strategy to use during the second half of 2020, Gunzberg says.

“At this point, taking on more risk on multiple levels may position investors favorably for the beginning of a new cycle,” she says. “Though we are looking to a new cycle, there may be doubt about the recovery if a second wave of the virus emerges.”

The current conditions in the market could result in buying opportunities in U.S. value, international and small-cap and mid-cap stocks, Gunzberg says. The federal stimulus package was directed at the consumer and small to medium businesses, which should benefit both disproportionately.

The financial, consumer cyclicals, materials, industrials and health care sectors are positioned well to “reflect a suitable position for where we are in this economic cycle,” she says.

The utilities, consumer staples and tech industries are less favorable based on where the market is in the cycle.

Value stocks will likely perform better than growth stocks in the short term, says Steve Sosnick, chief strategist of Interactive Brokers, a brokerage in Greenwich, Connecticut. The outperformance of growth stocks is so “phenomenal that it seems unsustainable in the longer term,” he says. “Ask yourself if Apple (ticker: AAPL) is 90% better off than it was a year ago. It wasn’t undervalued then, and the increase in its price-to-earnings has grown at essentially the same rate.”

Investors are paying a huge premium for the revenue and earnings certainty of the leading Nasdaq-100 mega-cap leaders and need to examine if the premium has become excessive.

“The problem is that those mega-caps such as Apple, Amazon ( AMZN), Microsoft ( MSFT), Alphabet ( GOOG, GOOGL) and Facebook ( FB) don’t fit neatly into a sector,” he says.

Rebounds in the market depend on several factors such as future earnings growth, higher inflation and a falling U.S. dollar.

During the past three recessions, the sectors that performed worst during peak to trough periods tended to have stronger forward-month returns, Gunzberg says. During the global financial crisis in 2008, financials performed worst, but then rebounded most over the next three, six, 12 and 24 months. A similar pattern occurred in 1990 and subsequent periods.

[READ: Fractional-Share Investing — Where to Invest.]

Impact of the Presidential Election

When a Democrat is president, the stock market rises by 11.1%, while a Republican president has resulted in an increase of 6.9% since 1945, says Sam Stovall, chief investment strategist at CFRA, a New York-based research firm. But the opposite is true when Democrats are in charge of the House — the market rises only 7.9%, and a Republican-controlled House results in the market increasing by 10.5%.

Since World War II, if the market declines during July 31 to Oct. 31, the incumbent gets replaced by the candidate from the other party, except in 1956, when President Dwight Eisenhower was reelected.

“The market is usually prescient about who gets elected,” Stovall says.

Returns of stocks in November could be lackluster because Wall Street hates uncertainty, but the returns in December are typically good, Stovall says.

Aided by low interest rates and a recovering economy, stocks should see strong earnings-per-share gains in 2021, with large-cap stocks predicted to rise by 30%, mid-cap stocks by 50% and small-caps by 150%, Stovall says.

The compound annual growth rate for the tech sector rose by 12.5% starting in 1990, while the S&P 500 increased by 9.5%. A retirement portfolio that allocated 50% into the tech sector and S&P 500 generated a return of 12.3% and was less volatile.

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Why Health Care and Financials Could See Gains

“Momentum is pointing at cyclicals — those are the ones you want to be sticking with,” Stovall says.

Real economy sectors such as financials, industrial, materials and even energy could come roaring back in the second half of the year if there is a vaccine for the coronavirus and the economy is able to open up 100%, says Shawn Cruz, manager of trader strategy at TD Ameritrade.

“Performance in the second half of 2020 could see Europe and Southeast Asia come back online and see a move out of Treasurys and safe-haven assets,” he says.

Returns for the financial sector, which includes the stocks of banks, lenders and credit card companies, do not look great, but these stocks are still arguably cheap, says Daren Blonski, managing principal of Sonoma Wealth Advisors in California.

“Their earnings are artificially suppressed right now because of set-asides for potential losses, and we don’t have accurate guidance on future earnings growth,” he says. “We will have to wait and see how extensive the damage is. Certainly with the most recent data coming from the banks, we are expecting massive losses akin to 2008 numbers.”

Investors often struggle to invest in companies or sectors that were impacted by large declines.

“But this is when you want to invest in those sectors,” Blonski says. “Retail investors are still chasing momentum in tech. That trade could be cooling, and perhaps exploring sectors still under strain would prove advantageous.”

The financial sector consists of 10.1% of the S&P 500 as of June 30, but there is a likely chance it will perform better than expected, depending on the percentage of losses that will have to be written off due to loan defaults.

“Unless the financial sector improves, it is hard for the S&P 500 to stage a long-term recovery,” he says. “At some point financials will come find their tailwind, but it’s a game for those that are patient.”

The financial sector appears to offer relative value because the negative factors are already priced in, including being hampered by low interest rates and the Federal Reserve’s putting a temporary lid on plans to return capital, Sosnick says.

“If they can make it through the coming earnings season unscathed, then they could see investors returning financials to favor,” he says.

Health care is an attractive sector through the end of 2020 and is the one defensive sector that also tilts toward growth, says Daniel Beckerman, CEO of Beckerman Institutional in Ocean Grove, New Jersey. The sector held up much better than the broader market during the 2008 financial crisis.

“If volatility remains with us through 2020, it will make sense to play defense on the equity side of the portfolio,” he says.

[Read: 3 Ways to Find an Undervalued Stock.]

Investors are willing to assign a higher multiple to companies that can grow faster in today’s low-interest-rate environment.

“There is a good bit of pent-up demand that will act as a tailwind for the health care industry through the year-end as much of the population postponed elective medical care in the first half of the year,” Beckerman says.

The health care sector has a steeper earnings recovery trajectory. It typically trades at a premium to the stock market, but it is currently the cheapest U.S. stock market sector after financials and trades at a 15% discount to the market, he says.

Investors should check their current allocations and ensure they are balanced across various sectors, Cruz says. One strategy is for investors to lighten up on Treasurys and bonds and increase equity allocation by 10 percentage points to 70% if they believe a coronavirus vaccine will be found soon.

“When there is underperformance in some sectors and great performance in sectors such as communication service and tech, a portfolio can get out of balance,” he says.

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