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These Two Sectors are Poised to Outperform in 2018

The stock market is so hot these days, it’s easy to overlook the merits of sector investing. After all, who wants to hear about the long-term merits of asset allocation? Most folks would rather brag about the quick profit they just made in a hot tech company.

But loading up on trendy momentum stocks may not be your idea of a good time. If so, then paying attention to sector performance can help you manage risk while generating consistent returns.

The S&P 500 Index is subdivided into eleven sectors (see chart below). Just as my IDEAL system can be used to score every stock in the index on a scale of 0 – 10, those same scores can then be combined to come up with an average IDEAL score for each index.

For the purposes of this exercise, I have omitted the Real Estate and Utilities sectors. That’s because they play by a different set of rules than most other stocks. But for the other nine sectors, my IDEAL system is a good judge of value.

Ranking the Sectors

You might guess tech stocks are the most overvalued. The tech-heavy Nasdaq 100 Index is up 32% over the past twelve months. But tech stocks are still fairly valued according to my IDEAL system with a sector score of 4.03. That is only slightly above the IDEAL score for the entire S&P 500 Index at 3.87.

You may be surprised to learn that Energy is the second best scoring sector with a score of 4.28.

It has been on a yo-yo the past three years due to extreme price swings in oil. It was the worst performing sector in 2014 and 2015 when oil prices plunged. It was number one in 2016 when oil prices finally bottomed out in the spring. But it returned to the bottom of the list through the first half of 2017, perhaps setting the stage for another banner year in 2018.

Here is what may surprise you. Healthcare nudges tech for the highest average IDEAL score at 4.31.

Healthcare was the worst performing sector in 2016, but it was second only to Information Technology through the first six months of this year. Barring a major change to the ACA in 2018, healthcare stocks should enjoy another solid year in the top half of the index.

Industrials Lose Strength

What surprised me is how overvalued the Industrials sector is compared to the others. Its IDEAL score of 2.59 is nearly a third lower than the index. That suggests it could be in for a tough year in 2018. Rising inflation and higher energy costs could squeeze profit margins for manufacturers next year.

Financials is the only other to have a score less than the index. That is unusual, in that most years at least 3 – 4 sectors score lower than the index. I’m not sure what that means, but it makes me nervous. It is also why I think you should think about which sectors you own the most of heading into next year.

To be clear, if the overall stock market goes through a correction then no sector will be spared.

But some will suffer more than others. The more overvalued sectors are likely to decline more than those that are undervalued. Longer term, rising interest rates may trigger a shift away from high-multiple growth stocks towards low-multiple momentum stocks. If so, then sectors that earn the highest scores for Relative Value should perform particularly well.

NOTE: You can see the IDEAL scores for every stock in the S&P 500 Index under the Data Tables tab of the Personal Finance website. 

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