At this late stage of the bull market, investors should look to technology and financial stocks as the equity sectors most likely to deliver significant future gains, according to Savita Subramanian, U.S. equity and quantitative strategist at Bank of America Merrill Lynch, in a lengthy interview with Barron's. "If there is another year to go, generally you want to own what is currently working, and that is momentum stocks. The two sectors that fit that are technology, even though it has wobbled lately, and financials."
The Case for Techs & Financials
As Subramanian tells Barron's: "Technology still offers secular and cyclical growth. It is the only sector with net cash on corporate balance sheets, and it has become an interesting dividend-growth story." Nonetheless, she recognizes that there are several risks: it's "a supercrowded sector and has had a great run;" it's surpassed financials as the sector with the most regulatory risk; and it's a globalized industry that is threatened by trade wars.
Regarding financial stocks, she notes that their earnings volatility has dropped markedly in recent years. From being the most volatile stocks in 2007, they now are the fourth-safest sector today, in her estimation. She adds that these companies have done much to improve their business models, yet this has gone unrecognized by many investors. This echoes earlier observations by longtime bank analyst Dick Bove, who sees banks entering a golden era, partly due to their adoption of advanced technology. (For more, see also: 4 Reasons Bank Stocks Will Rise Longterm: Bove.)
Valuation and Performance
As of April 6, the S&P 500 Index (SPX) had a forward P/E ratio of 16.88, while the tech-heavy Nasdaq 100 Index (NDX) had a ratio of 19.68, per a weekly calculation by Birinyi Associates reported by The Wall Street Journal. Meanwhile, the S&P 500 technology sector had a forward P/E of 17.4, the S&P 500 financial sector was at 12.8, and the full S&P 500 at 16.3, per calculations by Yardeni Research Inc. reported on April 4.
Through the close on April 9, the S&P 500 was down by 2.3% year-to-date, while the Nasdaq 100 was up by 1.2%. The S&P 500 Information Technology Sector Index (S5INFT) has risen by 1.6% YTD, while the S&P 500 Financials Index (SPF) has fallen by 2.3%, per S&P Dow Jones Indices. Subramanian and BofA Merrill Lynch forecast strong gains for the market through the rest of 2018. (For more, see also: Buy Stocks On BIg Sell-Offs, Says Citigroup.)
Stocks to Watch
Subramanian did not recommend specific stocks in her conversation with Barron's. However, an article in The Wall Street Journal makes the case that Google parent Alphabet Inc. (GOOGL) is a bargain at a forward P/E ratio of about 25, given that revenue and earnings are projected to grow at an annualized pace of about 15% to 20% during the next three years. More than 86% of its revenue comes from advertising, mainly related to search queries, in which Google is by far the dominant player. Meanwhile, advertising spending continues to move from older media to the internet, the Journal adds.
Goldman Sachs Group Inc. has been touting high growth stocks as a market-beating investment strategy. Among the tech stocks in their basket are Alphabet, semiconductor maker Micron Technology Inc. (MU), and information technology consulting firm DXC Technology Co. (DXC). The latter two stand out for especially low forward P/E ratios of 6 and 12, respectively, and low PEG ratios of 0.22 each, per Goldman's calculations as of March 15. Goldman projected 25% earnings growth for Alphabet in this report, and estimated its forward P/E as 28, for a PEG ratio of 1.12.
Among financials, regional bank holding company Comerica Inc. (CMA), and discount brokers E*Trade Financial Corp. (ETFC) and Charles Schwab Corp. (SCHW) also make Goldman's high growth list. Their respective forward P/E ratios were 15, 17 and 23, while their PEG ratios were 0.52, 0.77 and 0.85, per the same Goldman report. (For more, see also: 12 Growth Stocks That Will Win Long Term: Goldman.)
'Riskiest Bets in Today's Market'
Counterintuitively, Subramanian warns that supposedly defensive, high dividend yield stocks are the riskiest bets in today's market. She tells Barron's, "Low volatility funds are hugely overweight utilities, telecom and real estate investment trusts." The problems with these stocks, in her opinion: "These are three of the most levered sectors in the S&P 500. Payout ratios are close to 100%, so there is no room to increase dividends, and these companies have almost zero global diversification."
Also, she adds: "If you are buying a stock for safety, why does anyone care about price volatility? They should care more about earnings." She notes that these three sectors are among those with the highest earnings volatility in the S&P 500, and she expects them to be "the biggest potential casualties in a bear market." By contrast, she says that industrial, consumer cyclical, technology and financial stocks all tend to have "much less volatile earnings."
'High Secular Growth, Limited Earnings'
Subramanian tells Barron's that BofA Merrill Lynch is underweight in consumer discretionary stocks, which have surpassed technology stocks as the most crowded sector. This is largely the result, she says, of investors attempting to cut their risk by reducing their tech holdings. She observes, however, that "internet and catalog companies such as Amazon.com [Inc. (AMZN)] and Netflix [Inc. (NFLX)] make up a quarter of the sector's market cap, so it's a closet tech sector," adding, "Part of this group is companies with high secular growth but limited earnings that aren't throwing off cash."