This post was written with contributions from Anqi Dong, CFA, CAIA. Anqi is a Senior Research Strategist on the SPDR® Americas Research Team.
With each ebb and flow in the market, trends emerge that present opportunities for investors—provided they have the necessary tools for action. Because firms are closely aligned to specific economic variables and business cycles, sector-based strategies can help investors align portfolios with market events and seek to harness macro trends or shifts in fundamentals.
As the first quarter of 2019 gets underway, we see three opportunities where we believe investors can benefit from tactical positioning in sector-based strategies:
1. Capture noncyclical growth in health care
While analysts have downgraded S&P 500® Index earnings for 2019, earnings growth in the Heath Care sector remains intact on the back of stable demand and strong product pipeline, as shown below.
Source: FactSet, as of 12/27/2018.
Past Performance is not indicative of future results. It is not possible to invest directly in an index.
In 2018, the FDA approved 59 novel drugs, exceeding last year’s record for the second consecutive year. A record number of FDA novel drug approvals over the past two years is likely to fuel sales for new drugs in coming years. In addition, with an aging population driving demand for more medical services and products, US national health spending is projected to grow at a faster rate than normal GDP growth between 2017 and 2026 and more rapidly than the 2008–2016 period, benefiting the sector on a broad basis.1
Lastly, the Health Care sector also tends to have higher return to equity and stronger balance sheet than the broader equity market, exemplified by high free-cash-flow-to-debt and low debt-to-EBITDA ratios.2 In a late cycle environment with financial conditions becoming tighter and economic growth decelerating, Health Care’s high-quality balance sheet may better position portfolios to navigate a downhill climb.
To position for increasing health care spending and decelerating broad economic growth, consider an allocation to the Health Care Select Sector SPDR ETF (XLV).
2. Ride on a downward trend of long-term yields
Consumer Staples has been one of the least-favored sectors since mid-2016, underperforming the broad market by 16% annually as interest rates rose and economic growth accelerated.3 However, as long-term interest rates have started to head south on the backdrop of decelerating growth prospects, Consumer Staples have played a good defense in the equity market.
As shown below, the sector’s relative performance to the broad market has moved in the opposite direction of long-term yields. Since December 2007, the Consumer Staples sector outperformed the broad market by 0.95% on a monthly average two-thirds of the time when yields on the 10-year Treasury fell.4
Source: Bloomberg Finance L.P., as of 12/20/2018. Past performance is not a guarantee of future results.
In addition, the Consumer Staples sector has historically shown quality traits, such as higher return on equity and sufficient free-cash-flow-to-debt ratio. With less elastic products, Consumer Staples companies are more capable of passing on increasing input costs to consumers to maintain stable margins or navigate a slowdown in economic growth.
To position for falling long-term interest rates from a growth slowdown, consider an allocation to the Consumer Staples Select Sector SPDR ETF (XLP).
3. Seek attractive valuations with improving profitability
Even as the yield curve flattened in 2018, bank net interest margins continue to expand, as shown below. Banks have been able to reprice rates on their assets at a faster rate and in a greater amount than liabilities, elevating the return-on-asset ratio to the highest since 1986.5
Source: Federal Reserve Bank of St. Louis, as of 9/30/2018.
Banks are also poised to benefit from easing financial regulation. Following the approval of the Economic Growth, Regulatory Relief and Consumer Protection Act in May 2018, the Federal Reserve Bank proposed significant rollbacks of Dodd-Frank, including looser capital and liquidity requirements for large and regional banks. This is likely to reduce compliance costs and boost return of capital to shareholders in 2019.6
Additionally, the fourth-quarter 2018 selloff has created attractive valuation opportunities for bank stocks. They are trading at the lowest level based on forward price-to-earnings since October 2011 and nearly in par to their book value.7 Relative to the broad market, they are at the bottom quintile over the last 15 years based on price-to-book and price-to-forward earnings.8
To position for easing financial regulations and improving shareholder returns with attractive valuations, consider an allocation to the SPDR S&P Bank ETF (KBE).
1National Health Expenditure Projections 2017-26, Office of the Actuary, Centers for Medicare and Medicaid Services, as of 2/14/2018.
2FactSet, as of 12/31/2018.
3Bloomberg Finance L.P. for the period from 6/30/2016 to 9/28/2018, as of 12/20/2018.
4Bloomberg Finance L.P., as of 11/30/2018.
5FDIC Quarterly Banking Profile, as of 11/20/2018.
6“Federal Reserve unveils proposal to ease regulations for larger banks,” Thomson Reuters, as of 10/31/2018.
7Bloomberg Finance L.P., bank stocks are represented by the S&P Bank Select Industry Index. As of 12/31/2018.
8FactSet, as of 12/31/2018.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
An approximate measure of a corporation’s operating cash flow that is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
Earnings Per Share (EPS)
A profitability measure calculated by dividing a company’s net income by the number of shares outstanding.
Net Interest Margin
The difference between the revenue that is generated from a bank’s assets and the expenses associated with paying out its liabilities.
Price-To-Book Ratio (P/B)
A valuation metric that compares a stock’s price to the company’s book value, which is calculated by its total assets minus intangible assets and liabilities.
Price-To-Earnings Ratio (P/E)
A valuation metric using the ratio of the company’s current stock price versus its earnings per share.
Return on Equity (ROE)
The return on equity ratio, or ROE, is a profitability ratio that measures the ability of a firm to generate profits from shareholders' investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders' equity generates.
S&P 500 Consumer Staples Index
The index seeks to provide an effective representation of the consumer staple sector of the S&P 500 Index. The Index includes companies from the following industries: food and staples retailing; household products; food products; beverages; tobacco; and personal products.
S&P 500 Health Care Index
The index seeks to provide an effective representation of the health care sector of the S&P 500 Index. The Index includes companies from the following industries: pharmaceuticals; health care equipment and supplies; health care providers and services; biotechnology; life sciences tools and services; and health care technology.
S&P 500 Index
A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.