Sector Views: Monthly Stock Sector Outlook

Schwab Sector Views is our six- to 12-month outlook for stock sectors, which represent broad sectors of the economy. The Schwab Center for Financial Research (SCFR) combines a factor-based approach with a market and economic assessment to determine the ratings. For the basics on sectors, please see Stock Sectors: What Are They? How Are They Used?

We have upgraded Communication Services, Industrials and Health Care to Outperform, based on their generally solid fundamentals and potential ability of the first two to benefit from artificial intelligence adoption. We have downgraded Consumer Discretionary, Real Estate and Utilities to Underperform, based partly on the pockets of consumer stress we're seeing, especially among lower-income consumers, as well as challenging fundamentals (such as a mixed outlook for the office sector). 

(Sectors are listed in alphabetical order)

Positives: Companies tend to rely heavily on advertising and subscription-type revenue, which tends to rise when the economy is expanding. The artificial intelligence (AI) buildout continues to favor the large hyper-scalers—boosting the earnings profile of the sector.

Risks: If AI hype grows to be excessive, turns in sentiment can negatively impact the sector, especially if it becomes more dominant in the momentum trade. A persistent risk is the dominance of bigger members, which command a large share of the sector's market cap and thus determine much of its performance.

Positives: Companies tend to be sensitive to economic activity, as consumers buy discretionary items more readily when job growth is strong and interest rates are low.

Risks: Concentration risk is high for the sector, with the two largest members accounting for nearly half of the total market cap  The other half of the sector is also at risk of any further softening in consumer spending and/or a sluggish recovery in the housing sector, not to mention high tariffs.

Positives: Consumer Staples companies tend to be relatively insensitive to economic activity, as consumers buy staples regardless of economic conditions.

Risks: Companies can face shrinking profit margins in an inflationary environment without the pricing power to offset higher costs. Higher tariff costs may not be absorbed well by companies, and they might also face consumer pushback if prices are hiked.

Positives: Energy stocks are generally supported by relatively high oil prices, which can firm when global economic growth accelerates. Supply shocks can potentially put downward pressure on oil supply, which can put upward pressure on prices.

Risks: Earnings growth might struggle if oil prices continue to fall on the heels of both relatively weak demand and a continued recovery in supply. While Energy tends to be cyclical and to do well when the Federal Reserve is cutting rates slowly, global commodity prices (particularly oil) typically fall under pressure if growth continues to slow.

Positives: Some segments benefit from elevated interest rates, which allow banks to lend at higher rates and insurance companies to increase returns on collected policyholder premiums. The economy continues to look resilient, and with the Fed having cut rates a handful of times the lending environment has improved, especially for smaller companies.

Risks: If the labor market weakens at a faster pace—with the unemployment rate continuing to rise—Financials could struggle as consumers pull back on spending, businesses reduce investment, and lending slows. A continued slowdown in business confidence would likely bode poorly for the sector's earnings trajectory.

Positives: Health Care tends to do well even when economic growth slows, as most people will find a way to pay for necessary health care treatment even during tough economic times (although elective procedures often decline). It also can get a boost when heightened market volatility drives investors toward stabler choices.

Risks: Several companies in the sector (particularly in the biotechnology industry) have weak fundamentals. Downward pressure on earnings estimates is helping lift multiples—that is, stock price relative to earnings—especially for risky industries like biotechnology, which is a risk as interest rates stay elevated.

Positives: Industrials often benefit when economic growth raises business confidence, resulting in new building projects, machinery purchases, increased airline travel and shipments. The AI buildout has favored both the goods—and services—portions of the sector; increased building, materials, and power demand bode well for companies.

Risks: Industrials may underperform if tariffs eventually start to eat into profit margins and the manufacturing sector's recovery takes longer than expected. Key data points like the Institute for Supply Management (ISM) Manufacturing Purchasing Managers' Index (PMI) remain sluggish and inconsistent with an economy that is poised to grow.

Positives: Information Technology tends to do well when strong economic growth encourages companies to invest in technology upgrades and consumers to buy new devices. Some of the larger members are not in the "long-duration" camp—companies expected to produce their highest cash flows in the future—given they have current earnings growth and strong cash positions.

Risks: Technology manufacturers rely on a stable flow of components and can face significant risk from supply chain disruptions. Keeping up with the increasing speed of technology innovation can be a challenge. Tech is close to the epicenter of the global trade war, given the escalations in tensions with China.

Positives: The Materials sector historically is sensitive to fluctuations in the global economy, the U.S. dollar, and inflationary pressures. In a less-severe recession, the sector's profitability might not take as large of a hit.

Risks: Weakness in global commodity prices—in conjunction with sluggish growth in countries outside of the United States—can weigh on performance. A stronger U.S. dollar weakens sales abroad, and Materials relies heavily on foreign demand.

Positives: Real Estate, which consists primarily of commercial real estate investment trusts (REITs), tends to benefit from economic growth, which supports rent collections and property prices. Rate cuts can help to alleviate cost pressures.

Risks: Most REITs borrow heavily, making them vulnerable to elevated interest rates. The longer-term outlook for real estate is in question, given the unequal recovery across major metros.

Positives: The Utilities sector has tended to perform relatively better when economic growth slows, as consumers usually cut spending on other items before they stop paying utility bills. Expectations of more power generation due to artificial intelligence (AI) demand might continue to build.

Risks: The sector is getting into expensive territory (relative to history) when it comes to valuation. Any rise in Treasury yields has the potential to lessen the attractiveness of higher dividend payers like Utilities.

We begin with a data-driven evaluation of each of the 11 equity sectors. The sectors are then evaluated relative to the S&P 500 index to arrive at one of three preliminary ratings: Outperform, Marketperform and Underperform. Once confirmed, these ratings will reflect our view of how the sector is likely to perform relative to the S&P 500 during the coming six to 12 months.

The Schwab Center for Financial Research bases its ratings approval on a combination of quantitative data and a qualitative perspective on what's happening in the economy and markets. For example, there may be times when the data point toward a rating but SCFR's experts have strong reason to believe that an economic, market or geopolitical shift is underway that would change the sector outlook. 

Investors should generally be well-diversified across all stock market sectors. You can use the S&P 500 allocations to each sector, listed in the Sector Performance chart above, as a guideline. 

Investors who want to make tactical shifts in their portfolios can use Schwab Sector Views' Outperform, Underperform and Marketperform ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.

Schwab clients can log into their accounts and use Schwab's Portfolio Checkup tool to help assess their sector allocations. If they decide to make adjustments, they can use the Stock Screener to research particular sectors. Schwab's ETF Screener and Mutual Fund Screener also can help identify funds that specialize in particular sectors. Before considering any fund, you should consult the fund's prospectus to understand its investment objectives, risks, charges, and expenses. Investors and clients should consider sectors as only a single factor in making their investment decision while considering the current market environment.