Sector Views: Our Stock Sector Outlook

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders. 

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

So Liz Ann, big week last week. We got the PCE report, the personal consumption expenditures, and the deflator for that, which is the Fed's big inflation metric. What was your takeaway from those numbers? I see the stock market kind of liked it at first, and then maybe hasn't liked it so much after that.

LIZ ANN: To the extent you can tie stock market moves to any one particular thing, which I think is always a little bit tricky. Yeah, I mean, it was, I think, at least the consensus estimates I saw, it was sort of bang on the consensus. But you could have, I think, approached it with a little bit of a hawkish tilt just because of the month-over-month numbers or the longer-term 12-month rate of change, maybe not cooperating in terms of getting down to the 2% target near term. It didn't significantly move the needle in terms of probabilities around whether the Fed starts in May or they start in June or not at all, but that type of data is going to continue to wiggle with every combination of inflation report and particularly jobs report that comes out. 

So Kathy, what do you think Jay Powell and the other Fed Board Governors are making of this trend line in inflation? And do you think there's other significant factors like obviously the unemployment rate, wage growth, that would affect their decisions for the upcoming FOMC meeting this month or the subsequent couple of months of meetings?

KATHY: Yeah, I don't put too much weight on a month-to-month bump in, you know, core PCE as a big game-changer for the Fed. I think one of the problems the market has is the Fed's data-dependent, which means the market reacts to every single data point that comes out and extrapolates that data point long into the future and decides that the Fed is going to react to that. I don't really think that that's realistic. It's always a combination of data, as you suggest.

At this meeting, no one's expecting a change at the March meeting. I think the Fed's made that pretty clear. That's not going to be something that's going to happen. We may hear a little bit more about quantitative tightening. But the big questions are around how many rate cuts the Fed signals for the rest of the year, if any, and we'll be watching the dot plot where the various Fed members estimate where they think policy is going.

We're still in the three-rate-cuts-this-year camp. Inflation is still overall trending lower. Sure, there's some worries about the strength of the service sector, but it does look like we're still in a declining trend in inflation and heading towards that 2%. It's interesting to me too, I was reviewing some of the various rules that the Fed uses, such as the Taylor Rule, which is from John Taylor, where he tries to estimate what the appropriate Fed policy should be. And that's signaling that the Fed should cut. And that tends to be a relatively conservative metric. So here we are, bond market keeps moving sideways. The debate continues as to how much the Fed will cut, when they'll cut, if they'll cut. And I think we're waiting for some more data to come in before any big reaction happens. But we're still in the camp that inflation trends lower and bond yields will fall in the second half of the year. So Liz Ann, that's it for the bond market. But let's focus on equities this week. I know we've covered different sectors of the economy in various ways over the years. And I know that you'll be speaking with your colleague Kevin Gordon about various sectors. So what's changed in your approach to thinking about sectors of the market?

LIZ ANN: Well, one thing that has changed, or I guess has been relaunched, is our Sector Views. And that is after a couple-year hiatus for a whole variety of reasons, which we'll probably touch on, but we're very excited about those sector views. So there are ratings, on the sector level, all 11 sectors within the S&P 500®, of outperform, marketperform—think of marketperform as neutral—or underperform.

And there's both a quantitative component to that, driven by our colleagues and brilliant folks at Schwab Equity Ratings, and then a qualitative component as well. And the reason why I'm sitting down with Kevin for this podcast episode is he is going to run point on those sector views and talking about them and writing about them. So I thought he would be a perfect guest in discussing it. Doesn't shift us away from what has been as you know, Kathy, a factor-based focus, and that's in conjunction now with sector views, and factor is just another term for characteristic, investing based on certain characteristics. The good news is you can apply that type of analysis or screening within individual sectors. It's not just broadly at the overall market level. It can be applied at the sector level. So I'm excited about that conversation.

So I'm so happy to welcome my friend and colleague Kevin Gordon back to the podcast. He is my research associate, AKA my right hand, my right arm, my right leg maybe, in many ways. Well, he's one of my two incredible chart mavens, but also provides analysis on the economy and the market for Schwab's clients. And he helps develop deep-dive projects, he's been doing that for a number of years, as well as content for Schwab's public website, internal business partners, social media outlets. He is also a frequent guest on CNBC, Yahoo Finance, Bloomberg TV, CBS News, and gets regularly quoted in The New York Times, Forbes, MarketWatch, CNN, The Wall Street Journal, and Bloomberg. So Kevin, with all that said about your fabulousness, thank you for being here today.

KEVIN GORDON: Well, thanks for having me back. It's a joy to be on again.

LIZ ANN: So Kevin, I teased this earlier in the episode when Kathy and I were talking, and we're really excited, as I know you are, that we have relaunched what we call Sector Views, so perspective on and actual ratings on the 11 sectors that make up the S&P 500. So maybe let's start with why we went on hiatus with Sector Views, and what is new for people who remember what they were before, what's new about this freshly released version of Sector Views.

KEVIN: And I was thinking it's almost to the day actually two years ago that we put it on hiatus. And the original reasoning around it was because when the bear market started in January of 2022, it was followed, as you know, as many people know, unfortunately, by Russia's invasion of Ukraine, that really sparked a lot of volatility, not just in different global markets, but specifically within the U.S. stock market. So what we were seeing at the time was just these massive gyrations in sector leadership. And at the time, the way the sector model was constructed, it was just hard to provide outlooks based on how much that leadership was changing, particularly because we didn't have this factor-based approach that we now have. So what we now have, and what I love about it, is that it's this really great mix and really great blend of quantitative and qualitative. So it starts out with a quantitative approach. It's data-driven. We have five broad factors that really determine how we come up with these rankings. So it's growth, quality, sentiment, stability, and valuation. 

So it starts with a model centered around that which I have to put a plug in for and note was really driven by the Schwab Equity Ratings department, our friends there and sort of my teammate on this, Adam Lynch, they've just done a fantastic job in building out that model. But it runs through that, and then we'll take a qualitative approach, we meaning you, me, and members of the Schwab Center for Financial Research and the asset allocation group that we're a part of. And it's sort of this nice marriage of looking at all the data points and what they're telling us from the quant side, and then us taking our view from the macro and qualitative side, and if there needs to be an adjustment to a rating where we think strongly in one way, whether that's an outperform, a neutral, or an underperform, we'll make those adjustments. 

So the time that we took over these past couple of years was to really develop that quantitative-based model and then figure out a way and a process that made sense. So it's worked out really well. We're, you know, super proud of it, and it's nice for it to come back online literally and figuratively.

LIZ ANN: Yeah, and there's been ample demand for it. And to your point, this doesn't shift from what has been our factor-based approach, but it's the marriage of being able to do factor-oriented analysis, and for maybe new listeners or people that don't understand what that term means, factor is really just another word for characteristic. So looking for certain characteristics among stocks, having that added kicker of sectors that might have more positive bias or more negative bias onto which then you can apply factor analysis just helps the process of sort of whittling down and getting to some higher-quality ideas. So talk about actually what terminology we use around rating the sectors. You mentioned the five components that go into those ratings, but maybe even a little bit around what in essence is the sort of time horizon that sits behind what those ratings look like.

KEVIN: Yeah, so the three rankings that you'll see, or ratings that you'll see, in this that table we constructed, it's going to show up in the first one when you pull up the page for Sector Views, which is updated every month. So it's there front and center on the page in the article, and it's either going to be outperform or marketperform or underperform. And this is going to be over a 6-to-12-month horizon. We're not really looking to make these really quick shifts on a month-to-month or, you know, certainly not a week-to-week basis. We, you know, similar and tying in with our mantra of focusing on the long term and stability over the long term for investing, we really want to have that six-to-12-month outlook. So that's really what this is based on. And it's taking in a whole bunch of factors. Like I mentioned earlier, the growth one being things around earnings growth, what's the expectation for dividend growth? You've got the quality factor, which is looking more at "What's the profitability metric looking like? What's the earnings quality like? You know, are companies taking a more conservative investment spending approach?" And then there's the sentiment factor, which is really how investors and analysts feel about a particular company or a particular industry. And it's looking at how much those outlooks are shifting. And then the stability component with, you know, being earnings stability. So if there's low sales volatility, low trading volume, less turnover, those stocks tend to have higher stability scores. 

And then you've got the valuation component. So probably something that many investors are familiar with, "Are stocks trading really expensive relative to their free cash flow or relative to their earnings or relative to their sales?" So the model will take into account all of that. And what I really like is that we've got two tables in the report that comes out monthly and that is updated monthly. The first one is just going to show you each sector. So all of the 11 sectors listed. It'll show you their rating that we have, and then the subsequent table actually goes into all five factors and where the sectors rank in those factors. 

And it's nice because you can really see, you know, for a sector like energy, for example, right now, as we're having this conversation, ranks really well in the value, growth, and sentiment category, but not as much in quality and stability. So it's a little bit of a way for investors and viewers to see how we kind of justify this, especially from the quantitative angle, because, you know, it's not just some people sitting in a room and huddled and saying, "Yeah, energy looks fine on so-and-so metric." It really is driven by the data. And then we, as we talked about a little bit earlier, we do marry that with how we view things from a macro perspective.

LIZ ANN: So you mentioned energy as one of them, and this is sort of the cue-the-drum-roll part of our conversation. You know, what are our ratings right now across the 11 sectors? What say we?

KEVIN: Sure, so energy's in there. Financials and materials are also in the outperform category. And then it's probably easier if I just mention the two that are the underperforms because everything else would be in the neutral or in the "marketperform" rating. So real estate and consumer discretionary are in the underperform category. Real estate, probably not as much of a surprise if you're keeping an eye on what's going on in the commercial real estate space. There's just a lot of profitability struggle there that we see in terms of what the model is telling us.

And then consumer discretionary, there's sort of a blend of risks there. One of them being concentration risk, which I will note does not exist only in consumer discretionary, which we can touch on later, but there's also just, I think, a pared-back expectation this year—and you and I have talked about this a lot, Liz Ann—just of how much firepower the consumer has in the discretionary space in particular. So it's not as if we see the consumer completely falling off a cliff because we have benefited from, and the broader consumption base in the United States has benefited from, a relatively resilient labor market, certainly stronger than I think almost everybody was expecting even at this point in the sort of post-pandemic environment. But when you look at certain profitability metrics for companies in that sector, specifically on the cost front and the fact that they're still facing, if not, you know, just higher input costs on the sort of capital side, certainly higher input costs on the labor side. So that is an instance where sometimes the labor market strength kind of becomes a little bit of its own enemy because you have had labor hoarding to some extent, and it has shown up in some of these names. Retail is a big industry that's represented in the discretionary sector. So I think it's an important way to look at some of the balance of risks that exists in a space like that because, as I mentioned with concentration risk at the beginning, you do have the two largest companies in that sector being Amazon and Tesla, which are often thought of as tech, but they're not technically in that index, no pun intended. But when you look at just those two names, they're about 50% of the market cap of the discretionary sector. So automatically, if you're just investing in a cap-weighted sense and following that index or that sector, you are putting sort of a lot of risk in just those two names. You're at the mercy of their moves. So it works great when they're doing really well, not so great when they're doing poorly.

LIZ ANN: And get to the good stuff. What's the backdrop around the three sectors on which we currently have outperform ratings?

KEVIN: Well, it's interesting because if you go to that second table that I mentioned, whenever the listeners pull up the Sector Views page, they all rank differently in certain factors. So for financials, actually three of them are neutral. The two positives are value and quality, but that's enough to boost the sector to the outperform status. For materials, actually mostly neutral, you rank well in value; you don't rank well in stability. It's actually rated as a negative.

And then energy is this mix where value, growth, and sentiment look really well, but quality and stability don't. So earning stability for energy, for example, it's probably not, again, a surprise to see because of, certainly the volatility in global commodity prices over the past few years, but just this lack of, I would say, resurgence in oil prices, certainly against the grain, I think, of what the consensus was expecting for, you know, a relatively tense environment in the Red Sea, that really hasn't materialized in a material pickup in oil prices. You're not getting a lot of demand from, you know, around the world. You've got a couple of developed economies in recession. China has taken a little bit longer, you know, to see its demand come back. So there's enough downward pressure, I think, on oil prices that has, I would say, put almost commensurate downward pressure on the earning stability front of energy. And then for something like financials, you know, there's actually a lot of high-quality sort of factors that are doing well in the financial space. It sometimes, I think, gets masked by a lot of the stress that you see in the headlines associated mainly with the banking sector, especially when you move down the cap spectrum. 

But if you move up the cap spectrum, even in the mid-cap kind of space, there are a lot of companies that screen well, especially when you're looking for earnings profitability and earning stability. So I would just note that wrapped into this whole discussion about sectors, and you talked about this in our focus on factors over the past couple of years, as these sector views were on hiatus, we still want to maintain a focus on factors. And especially for investors who are a little bit more active-oriented in their approach, you can screen and you can use our own Schwab tools on the website. When you're logged in, you can screen for these factors, and you can find high quality in every single sector. 

So just because we've got an underperform right now on real estate and consumer discretionary, that doesn't mean that there aren't high quality companies in those sectors. So I think that's an important thing to note, especially when we're talking about how we want to use overall sector views, not as some sort of, you know, guideline where you have to adhere to it as an investor. Just because we've got these outperforms, it doesn't mean that you should shun everything else and only focus on those three sectors.

LIZ ANN: So are there any more, on that note, any more details around how investors should be using sector views, aside from what you just mentioned with regard to the overlap of factors into sector analysis?

KEVIN: I think from an informative perspective, meaning a lot of the sectors that I think get most attention these days are more mega-cap in nature. So probably tech, communication services, to some extent consumer discretionary because they do house what is often called the Magnificent Seven. You and I have talked a lot recently about why maybe that moniker doesn't apply as much anymore. But I think those are the three sectors that definitely get the most attention. Maybe you have some cyclicals that pop up sometimes, but not for the right reasons. They're typically underperforming. But I think it's helpful, especially if you're sitting there as an investor in a market environment like today where the momentum trade has really just seen an incredible rally. And oftentimes, tech, I think, itself just gets lumped in the momentum category, because that's sort of conventional wisdom. It is the case today where that has grown as a share of momentum. So the tech trade has become, and I would say tech adjacent, has become synonymous with what has been a really strong momentum trade. 

But what gets lost in that is some of the sectors that don't get talked about but actually screen really well. So I think of sector views not as some sort of rule book as to how every investor needs to place their money or place their overall investment and construct their portfolio. I think of it as, oh, maybe, "I have a lot of tech exposure." Or "It's completely out of what my thinking was originally for this portfolio, maybe I should consider things that look relatively strong." So if you want to jump into an area like financials or an area like energy, there are parts of those sectors that do really well. And even something like financials, since the Fed is in so much of the market discussion these days, that sector, when you look back at history, actually tends to do well in a slow, rate-cutting environment. So if the Fed's not aggressively cutting, presumably because there isn't a recession and they're not staring at some sort of crisis coming down the pike, an area like financials actually does pretty well. So I think that's something to consider, especially because we don't consider, I guess, the house view for us at Schwab is not one of the Fed pivoting aggressively to rate cuts that are larger in nature this year, of course, barring some sort of surprise. So those kinds of tidbits are really important to think of, especially when a couple of sectors get most of the spotlight these days.

LIZ ANN: So speaking of tidbits, but also caveats, I can't remember the last time we wrote a report where there wasn't a sentence or a little mini paragraph that starts with "Caveat:" because that's the nature of what we do in analyzing the entire U.S. economy and markets. Wouldn't it be lovely if it was always clear and distinct and streamlined? But …

KEVIN: It would be so nice.

LIZ ANN: You know, in closing, are there any caveats or other maybe unique tidbits that you'd like investors to know either about the whole nature of sector analysis and/or maybe how it blends on the factor side?

KEVIN: Well, I think I talked about concentration risk in something like discretionary, in the consumer discretionary sector. But I do think that it's become more important now, not only because you do have one of the most concentrated equity markets, at least in the U.S., in history, you've got the seven largest names on any given day making up 27 to 28% of the S&P 500's market cap. So that's a huge portion when you look back at history. But I think it's to know what you're buying.

And I think for consumer discretionary, knowing that Amazon and Tesla make up about half of that index. Same thing for tech. It's Apple and Microsoft making up half of that index, even for actually a sector like energy. Often doesn't get lumped into the concentration risk, but the two top companies there, the two largest companies, Exxon and Chevron, they also make up almost 50% of that sector.

Same thing with communication services. There's a lot more concentration risk, actually close to 70% when you look at the top two names. So I just think that it's about trying to minimize the amount of negative surprises that can come along the way, because if you're enjoying the tailwind from, you know, a couple of names that are doing really well if it's in a sector like tech, but one of those names happens to have a negative earnings surprise or something happens where the stock turns south, and it's being a drag on the overall index, I would much rather know that and be informed as the investor even if I'm really bullish on the sector. If I didn't know any of the concentration risk, I think it would come as more of a negative surprise, and it would be a little bit harder to understand what was going on. So I think the risk that you have from a couple of companies driving a lot of the action is really important, especially when we start to change these views in the future, because at some point it will happen. But when we, you know, bring some out of the outperform category or some into the outperform category, having that in mind, especially with the ones that I mentioned, I think that's really important.

LIZ ANN: Great info. Kevin, thank you so much. And for our listeners, part of the reason why I wanted to have Kevin on and have this conversation is not only do we want to share what we have on these new sector views and the relaunch, but for the most part, Kevin will be, let's call it our point person on Sector Views. So he will be in the hot seat, in general, going forward, so he is the man to listen to on this. So you can check out all of these updates and articles about sector views on schwab.com/SectorViews. That's all one word. And we will also have a link to that site in the show notes.

But Kevin, as always, thanks for joining us on the podcast today.

KEVIN: Thank you. It's always a pleasure. Thanks so much for having me.

KATHY: We are recording this one a little earlier in the week than we normally do, so we won't be addressing the jobs report or Fed Chair Powell's testimony before Congress or a number of other economic reports that are coming out, but if you follow us on social media, we will be posting a lot of information there to follow up on those events, so please keep an eye out there. And we're taking next week off for Spring Break. With that in mind, Liz Ann, what's on your radar for the next couple of weeks?

LIZ ANN: So in terms of next week when we're actually off, it's a big week of data, not least being CPI and PPI. And I don't think we have to explain to this audience why those reports are important. But one that I pay a lot of attention to that's coming out next week is NFIB, National Federation of Independent Business. It's a small-business survey. And there's the headline overall index level that's always of interest. But it's a lot of the component questions that can be fairly interesting. Its expectations around employment and prices. There's also a single-most-important-problem question, where, maybe not a surprise, inflation has been at or near the top, but that's given way a little bit. And interestingly, concerns about finding skilled workers has been bouncing back up a little bit. And that's interesting because that had been the dominant problem during the earlier part of the pandemic when it was very difficult for these companies to attract the kind of workers that they were looking for. 

Retail sales comes out next week. That has been a needle-mover in terms of just perspective on the economy, but also just the health of the consumer. And the most recent retail sales report was on the weaker end of the spectrum. So we'll have to see whether next week's report suggests that that's a continuing trend. And then we also get the University of Michigan version of consumer sentiment, which is a companion to consumer confidence. Consumer confidence tend to be biased more by what's going on in the labor market, but University of Michigan consumer sentiment tends to be biased a little bit more by what's going on with inflation. So in conjunction with those CPI, PPI reports, that could be of interest as well. What's on your radar, Kathy?

KATHY: Well, all those economic data points will be significant for the bond market, obviously. We are keeping an eye on a couple of other things. In particular, this week is Super Tuesday in the 2024 election. Our colleague Mike Townsend always points out that the congressional races and control of Congress usually ends up having more of an impact on issues that affect your finances than I think a lot of people realize.

And so if you aren't already following his podcast, WashingtonWise, now's a good time to seek it out. He works hard to maintain a pretty neutral view of the political landscape. And if you don't believe me, go read the reviews of the show on Apple Podcasts. You can find WashingtonWise on any podcast app or on our site at schwab.com/WashingtonWise, all one word.

LIZ ANN: So thanks for listening, everyone. You can always follow us for free in your favorite podcast app. And if you've enjoyed this episode, tell a friend about the show or leave us a rating or review on Apple Podcasts. And by the way, thank you to everyone who has left a review so far, especially the good ones. But I suppose we should say thank you for any of the bad ones too. But we do always enjoy reading your feedback on the show.

KATHY: And, as always, you can follow our updates on X, formerly known as Twitter, and LinkedIn. I'm @KathyJones—that's Kathy with a K—on Twitter and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders—Sonders is S-O-N-D-E-R-S—on X, or Twitter, and LinkedIn.

KATHY: For important disclosures, see the show notes or schwab.com/OnInvesting.