Which U.S. Stock Market Sectors Have the Best Prospects Over the Next 12 Months?

Of the 10 sectors that comprise the U.S. stock market, Global Insight’s Sector Rotation Strategy recommends that the consumer staples and healthcare sectors be given an overweight position relative to the MSCI USA benchmark for investing over the next four quarters. By contrast, the energy, consumer discretionary, and utilities sectors have relatively poor fundamentals for investment.

Currently, the consumer staples sector has a sizeable overweight recommendation, helped in part by its "defensive" nature in a slowing economy. The companies in this sector often show consistent earnings growth over the course of the business cycle since they sell relatively "inelastic" products and services. This feature is reflected in lower measures of volatility in stock prices and earnings growth rates than is typically seen in other sectors.

An attractive sector valuation also boosts the relative prospects for total future return from consumer staples. Despite seeing stock prices rise in line with those of the overall market (as shown by the neutral momentum indicator), the dividend yield from this sector is still comparatively high. In addition, both the dividend yield and payout ratio are rising. Further, while a sector P/E for consumer staples of 19 is not particularly low when compared to other sectors, it is lower than its own history (consumer staples have a 10-year average P/E of 23). The forward growth of profits from this sector is strong enough to lower the "PEG" ratio to an even more historically attractive range, and to raise the Free Cash Flow "turning point" indicator well above one. In addition, the improving fundamental indicators are also a large factor in determining an improving credit outlook for this sector.

The healthcare sector also merits an overweight recommendation from both fundamental and risk perspectives. Despite seeing its own stock price momentum lag behind the overall market during the past year (shown by a negative reading on the momentum indicator), healthcare still supports on average a reasonable dividend yield. Furthermore, the yield has been rising in recent years and now stands some 6% above the sector's own historic average. Perhaps the most attractive aspect of this sector is the robust prospect for future earnings growth due to faster sales and positive pricing power. Relatively fast profit growth raises the FCF turning point indicator up to a very attractive 1.3, and lowers the PEG ratio down to a level that is less than one-half the value seen on average historically in this sector.

Like the healthcare and consumer staples, the industrials sector is relatively undervalued, while its earnings trend remains intact. However, industrials is usually more economically sensitive than are these other two sectors. In recent years, this feature has supported the industrials sector as shown by a positive reading in the momentum indicator. However, the outlook now is for a slowing economy and a tough pricing environment for industrial commodities and supplies. Fortunately, the U.S. industrials sector performance will be boosted by strong earnings from overseas, as a weaker dollar and robust demand from Asia will support a still-healthy growth rate for sector profits. So, while the performance of industrials remains very solid to date, a worsening perspective for future credit quality tempers what would otherwise be a solid over-weight recommendation for the industrials sector.

The financial sector is by far the largest sector in the market so the sector rotation strategy must take a view on what kind of exposure should be placed here. The recommendation for the financial sector as a whole is for a neutral setting within the portfolio, but this is largely due to diverging trends among several of the key sub-sectors within financials. For example, the prospects for the real estate sub-sector are very poor, with an under-weight setting indicated by both the fundamental and credit indicators. However, the outlook for the insurance and, to a lesser extent, banking sub-sectors is positive on balance. If real estate were to be excluded from the financials sector, the remaining components themselves would warrant an over-weight recommendation in the overall portfolio.

By contrast, the relative view of the energy and consumer discretionary is unambiguously negative, for related reasons. The energy sector's future prospects are in large part a victim of success of the recent past, having enjoyed by far the biggest run-up in stock market prices over the past few years, largely on the strength of steadily higher oil prices. However, while high oil prices are expected to remain in place for several years—supported by strong demand from China and other fast growing emerging markets—the prospects for further rise in prices are capped by an expected slowdown in the U.S. economy and price-induced attempts to lower demand.

The consumer discretionary sector is similarly sensitive to the impact of a slowing U.S. consumer market. The dividend yield for this sector is unattractive, and the prospects are further clouded by a negative reading in both the credit risk indicator and the technical momentum indicator.

Our Sector Rotation Strategy is produced as part of our World Industry Service's Stock Sector Benchmarks, designed to assist asset managers in identifying the most profitable sectors for investment in the U.S. and international stock markets. This service is updated on a quarterly basis for all clients of this service.

A full description of the Sector Rotation Model and factors driving the current recommendations are available to subscribers on the Cost and Industry section of the Global Insight Web site.

Additional information on the World Industry Service, which provides the platform and fundamental forecasts for the Stock Sector Rotation Model, is available at the following links:

• World Industry Service
• WIS Stock Sector Benchmarks
• WIS Sector Risk Ratings

Figure 1

Recommended Portfolio Weighting for 10 U.S. Stock Market Sectors over Next Four Quarters

Over (+), Equal (=) or Under (-) Weight Setting relative to the Portfolio Benchmark

Figure 2

Recommended Portfolio Weighting for U.S. Financial Industries over Next Four Quarters

Over (+), Equal (=) or Under (-) Weight Setting relative to the Portfolio Benchmark

(1) Over/under-weight setting from Global Insight WIS Stock Sector Rotation models

(2) July 2006 Sector Price Index divided by the average from the previous 12 months

(3)Expected level of deterioration or improvement (over 2005-2007) of the Sector Risk Rating, divided by the 2006 level of the risk rating

August 2006

by Mark Killion, CFA, and Natasha Muravytska