5 Stock Sectors Poised To Outperform: Goldman

Some investment strategists are recommending a portfolio rotation towards defensive stocks, given their expectation that both the U.S. economy and the stock market are nearing tops. Goldman Sachs has a different view and favors what it calls high beta cyclical stocks. This group "should continue to outperform defensives in this above-trend economic growth environment," they write in a recent report, adding, "simply put, cyclicals offer similar earnings growth but better value than defensives." Underpinning their recommendation are two further observations: "the current state of the U.S. economy is strong" and "higher interest rates should also benefit cyclicals relative to defensives."

Goldman defines cyclicals in a very different way than many firms. Goldman has a very broad definition and calls them "industry groups with higher betas to the US economy than the S&P 500 Index (SPX)," with most of them being classified in the financial, industrial, energy, materials and information technology sectors of the S&P 500. In their U.S. Weekly Kickstart report dated June 15, Goldman did not recommend specific stocks in each sector. However, for illustrative purposes, here are three representative stocks in each sector:

Source: BarChart.com

As calculated through June 14, Goldman finds that cyclicals have beaten both defensives and the S&P 500 on a total return basis, which includes price appreciation plus dividends. Cyclicals also offer cheaper valuations. However, defensives have outperformed so far in 2018.

 Source: Goldman Sachs; data as of June 14.

Forward P/E ratios were computed based on estimates of next 12 months' earnings.

Goldman is projecting that U.S. economic growth will remain above trend through 2019, with real GDP increasing by 2.9% in 2018 and by 2.2% in 2019, versus an estimated trend of 1.8%. They note that a wide variety of economic statistics released so far in June have exceeded consensus expectations, such as payroll data, the unemployment rate, the ISM manufacturing and non-manufacturing indexes, JOLTS job openings, the NFIB small business optimism index, and retail sales data. By contrast, they find that growth is slowing in Europe and the rest of the world.

In their estimation, the odds of a recession in the U.S. will increase from 4% during the next 12 months to 32% during the next three years. Thus, they expect that economic expansion is likely to persist through 2020. As a result, they forecast a continued rise in the S&P 500 Index through the end of 2020. Goldman sees the index reaching 2,850 by the end of 2018, up by 3.5% from the June 21 open. After that, they call for a 5% rise to 3,000 in 2019, and a 3% gain to 3,100 in 2020.

The report indicates that rising interest rates will be more favorable to cyclicals than to defensives. The main reason: "the cyclical financials sector carries the strongest positive correlation with rising Treasury yields of any sector or factor. In contrast, "bond proxy" defensives, such as utilities, telecom services, and consumer staples, typically underperform alongside rising interest rates."

Goldman believes that the Federal Reserve will raise interest rates two more times in 2018, and four times in 2019. As a result, they see the Fed Funds Rate reaching 3.4% by the end of 2019, about 150 basis points higher than today. Meanwhile, they expect long-term yields to rise more slowly over this same period, increasing by about 65 basis points to 3.6%.