Among the 10 sectors that comprise the U.S. stock market, the healthcare sector currently has the best attributes for an overweight position, from both the fundamental and risk perspectives. This is due to the robust prospects for strong growth in earnings and free cash flow that result from positive demographics, new technology, faster sales, and positive pricing power.
The consumer staples sector has a sizeable overweight recommendation, helped in part by its "defensive" nature in a slowing economy. This is reflected in lower measures of volatility in stock prices and lower earnings growth rates than is typically seen in other sectors. A very attractive sector valuation also boosts the prospects for future returns from consumer staples.
Also, on the whole, positive outlooks can be found in the insurance and, to a bit lesser extent, the banking industries within the financial sector. These will be supported by continued economic expansion, albeit at a slower pace, generally good asset credit quality, sound capital ratios, and reasonably strong financial markets. Nonetheless, there are growing pressures from an inverted yield curve and stiff competition for loans and deposits. Further, the growth rate of demand for new loans is expected to slow in both consumer and commercial credit in 2007. Perhaps the largest source of slowdown in the financial sector will be related to the housing sector; the prospects for returns from investing in the real estate sub-sector are very poor, with an under-weight setting indicated by both the fundamental and risk indicators. The fallout from declining real estate sales will also affect areas of the financial sector, such as regional banks and mortgage-related institutions that have large exposure to the real estate markets, as well as real estate brokers and developers.
The energy and consumer discretionary sectors are expected to have the least favorable prospects in 2007. The energy sector's future prospects are in large part a victim of success of the recent past, having enjoyed by far the biggest run-up in profits and stock market prices over the past few years, largely on the strength of steadily higher oil prices. However, the prospects for further rises in prices are capped by an expected slowdown in the U.S. economy and price-induced attempts to lower demand. In addition, dividend payouts from the energy sector have not kept up with the growth in profits in the past few years, which has driven the energy sector's dividend yield down to unattractive levels, and lowered the dividend payout ratio to one-third the amount normally seen on average since the 1990s. Further, many portions of the energy sector are committed to large scale projects and capital investments in coming years, the spending for which will push down on the growth of their free cash flow.
The outlook for a slowing economy will also hurt the consumer discretionary and industrials sectors, which traditionally have been the most economically sensitive sectors in the market. In addition, the consumer discretionary sector has very poor fundamental valuation parameters such as low dividend yield, high P/E and PEG ratios, and low forecast growth in sector profits and free cash flow.
Portions of the industrials sector will also be vulnerable to slowing domestic growth, such as those exposed to the weak U.S. automotive industry, and adverse market conditions for the construction sector. The prospects for return in industrials are further clouded by a negative reading in both the credit risk indicator and the technical momentum indicator.