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It's Stock-Picking Time: Finding Sector Bright Spots

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April 8, 2015
It's Stock-Picking Time: Finding Sector Bright Spots

As the door closed on first quarter the S&P 500 eked out a modest gain of 0.4% to end the first three months of the year. Digging deeper into individual sectors, investors will discover a much more interesting and tradable picture. For example, health care outperformed the S&P 500 in the first quarter, as Health Care Select Sector Index ($IXV) chalked up gains totaling 6.25%. Meanwhile, utilities were a clunker in the first quarter with the Utilities Select Sector Index ($IXU) posting a solid 6.06% decline.

Time to be Choosey

"This is a stock-picker's market," said Eric Utley, Curriculum Development Manager at Investools. "At any given time there are sectors moving up and sectors moving down. If you can identify sectors that are outperforming [the broad market] and avoid the sectors that are underperforming [the broad market] you might have an opportunity."

This approach is "highly underrated by the retail investor," said JJ Kinahan, chief strategist at TD Ameritrade. "Retail investors tend to just look at the broader market, while the professionals look at what are the good sectors and what are the bad sectors.”

Key Drivers for Recent Sector Activity

Traditionally, investors flock to the utilities sector and also real estate investment trust (REITs) investments for higher dividend yield and income performance. But, first quarter returns in the utility sector crumbled as investors priced in expectations for short-term interest rate hikes by the Federal Reserve.  Real estate investment trusts (REIT), another interest rate sensitive sector, were extremely volatile in the first quarter also due to the uncertainty over the Fed hiking short-term interest rates. "Investors generally look to these types of securities for their income and yield. If the Fed starts to raise rates it makes those yields a little less attractive," said Utley.

Last week's release of the March U.S. employment report may have been a game changer for the Federal Reserve, as non-farm payrolls rose a disappointing 126,000 (nearly half of what was expected). That number broke a 12-month streak of gains of over 200,000 new jobs per month. Markets reacted swiftly, pushing out the expectations for the timing of the first Federal Reserve rate hike from June to September. In turn, this could usher in a rebound to the beleaguered utility sector.

"Utilities are very interest rate sensitive. The sector may get a little boost as Fed rate hikes get pushed out until later in the year," said Utley.

Time for Investors to do Their Homework

There are broader trends that investors can monitor. According to a Morningstar quarter-end insight research report, "Cyclical and defensive sectors have been taking turns leading the market higher, which has left both overvalued. In our view, industrials, technology, health care, consumer defensive, and utilities are the most overvalued sectors, with the median stock in each trading between 7% and 11% above our fair value estimates. Only energy looks like a relative bargain, with the median stock trading 9% below our fair value estimate."

Investors can follow sector performance on a regular basis in order to gain insight into these trends. It can be as simple as tracking sector losses/gains on a daily basis for the active trader or on an end of month basis for a longer investor. Just log on to your account at tdameritrade.com to check out the Sectors & Industries page.

Sector performance tool from TD Ameritrade

FIGURE 1:

TD Ameritrade analytics tools under the Research & Ideas tab at tdameritrade.com allows investors to track sector performance. For illustrative purposes only. 

What’s the Punchline for Investors?

This type of analysis also offer opportunities for "pairs trading," where an investor buys one sector and sells another sector (in this case, sell short). "Buy what you think is strong and sell what you think is weak," says Kinahan. In the first few days of the quarter it will be interesting to monitor to see if those trends will continue. Are we going to see a continuation of money going into the stronger sectors? Or, will people start buying sectors they think are undervalued?" says Kinahan.

Please keep in mind that pairs trading requires active monitoring and management and is not suitable for all investors. Also, the risk of loss on a short sale is potentially unlimited. 


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