These Two Beaten-Down Sectors Deserve A Second Look

The mini-rally in stocks at the end of January has turned back into a full-blown selloff and investors are once again wondering if the seven-year bull market has run its course. Oil prices continue to crash lower and few are left touting the future of America’s revolution in energy production. 

Stocks in the S&P 500 have fallen more than 14% from their 52-week high — now well past a correction and approaching the 20% bear market signal as fourth quarter earnings give investors little to cheer. 

#-ad_banner-#But we’ve been here before. Several times in fact. There have been three other corrections of 10% or more since 2009. And in their despair, investors are overlooking some powerful catalysts that could take shares back up and beyond old highs.  And I think it looks especially likely that this will happen in two of the hardest-hit sectors.

Is The Bull Market Stampede Officially Over?
Corporate earnings are set to decline for three consecutive quarters, a trend not seen since 2009, and reported sales are down for four straight quarters according to FactSet Research. Slowing growth from China and the near collapse of the energy sector have got investors worried that the bull market has run out of steam. GDP growth in the United States came in at an annual rate of 0.7% in the fourth quarter.  That’s less than half the growth booked in the same quarter 2014.

Much of the worry is that higher interest rates will slow the U.S. economy just when corporate profits are already weakening. Investors are rushing out of cyclical sectors, sending consumer discretionary and financials both down more than 12% since the beginning of the year. Meanwhile, stocks of relatively-safe utility companies are up more than 6% for the year and the consumer staples sector is down less than 3% over the period. You can see these performances in the chart below, showing the Consumer Direct Select SPDR ETF (NYSE: XLY), the Financial Select SPDR ETF (NYSE: XLF), the Utilities Select SPDR ETF (NYSE: XLU), and the Consumer Staples Select SPDR (NYSE: XLP).

But despite weakness in corporate earnings, economists at Goldman Sachs see less than an 18% chance that the United States will fall into recession this year and only a 23% chance by the end of 2017. Analysis by Deutsche Bank on U.S. rate cycles over the last 35 years shows that stocks end the year after the first rate hike up 2.6% on average. That would put the S&P 500 back up to 2,094 by the end of the year, a gain of 14.7% from the current level. 

The collapse in oil and gas prices has rocked the energy sector and its 74% decline in earnings accounts for the majority of corporate earnings weakness. Excluding energy, fourth quarter earnings for S&P 500 companies would be higher by 2.2% over last year. There may also be a lagging effect at play that could drive the economy going forward. The job losses and lower corporate spending in the energy space have hit the economy over the last year but consumers have yet to spend their windfall from lower gasoline prices. 

The biggest catalyst for a rebound could come from the economy’s biggest contributor. Household income jumped 4.5% in 2015 for the largest increase since 2012 and the increase in disposable income was the largest since 2006. Household savings increased to $753.3 billion, more than 9% higher than the $690.2 billion saved away in 2014. Consumer spending accounts for 70% of U.S. GDP and may be ready to surprise higher as shoppers open their pocketbooks.  

Besides growing household savings, spending could get a boost this year from available credit. Credit scores of U.S. consumers are starting to rebound from the financial crisis. The median credit score on mortgage originations increased to 780 last year from 720 in 2007. 

The Worst Performers Could Be Your Best Bet
The two sectors hardest hit by the selloff could be two of the biggest beneficiaries of economic catalysts this year. Investors have abandoned consumer discretionary and financials, offering more rational investors better valuations and higher dividend yields.

The Financial Select Sector SPDR ETF (NYSE: XLF) has come down to 11.7 times trailing earnings from 13.7 times at the end of 2015. Slightly higher rates should improve the net interest margin for banks without choking off loan growth. Legal costs related to the financial crisis are starting to subside helping big banks like Goldman Sachs and Bank of America beat earnings expectations. On average, the sector posted a 0.7% beat on Q4 earnings estimates and 10.4% earnings growth in 2015. The fund pays a 2.1% dividend yield and holds shares of 87 firms in banking, insurance, investment and REITs.

The Consumer Discretionary Select Sector SPDR ETF (NYSE: XLY) has come down to 17.9 times trailing earnings from a valuation of 20.5 times at the end of 2015. Higher wages on a tightening job market could mean a boom in consumer spending as inflation remains benign and low gas prices put more money in consumers’ pockets. Nearly three-quarters (70%) of consumer discretionary companies beat earnings estimates for the fourth quarter, the fourth best performing sector, and only 14% missed estimates. On average, the sector posted 11% earnings growth in 2015 and pays a 1.5% dividend yield.

Risks to Consider: Odds of a recession by the end of 2017 increase to 23% and weakness in other large economies could pull down global growth.

Action to Take: Take advantage of the selloff for a position in consumer discretionary and financials ahead of the rebound over the next few quarters.

Editor’s Note: If you love big fat yields of 18.7%, 13.3%, 9.8% or 15.3%, then NOW is the best time to join High-Yield Investing. Find dozens of the highest-paying cash cows to boost your income for only $29.95 for a full year. Hurry! This special President’s Day offer ends February 16 and you won’t see it repeated again this year! Click here.