2010 Sector Outlook: XLK, XLV, XLU, and XLE

Technology, health care, utilities, and energy appear to be the sectors most poised for outperformance of the market at large in 2010. Although nobody can effectively and reliably predict the sector movements at any given time (and sector rotation strategies are a high-risk, high-reward proposition), the current macroeconomic factors at play lead me to believe that these four areas will perform well in 2010. The corresponding Select Sector SPDR ETFs are XLK, XLV, XLU, and XLE. Here is a breakdown of these four industries.

Technology

Although technology had a huge upswing in 2009 (up 54%), I still think there is room for continued upside as the valuation on a forward P/E basis is still reasonable. The close of XLK today was 20.84 - a level in the trading range of 18.3 -22 that XLK was in from the beginning of 2004 until September 2006. XLK is down about 9% YTD, making it a good entry point at this time in my mind. Although this move has been on some considerable volume, which causes me some concern as high volume often indicates that a move is legitimate. Nevertheless, I see technology as the single most important catalyst in the worldwide economy for continued recovery and growth. And I'm cautiously optimistic that we will see that growth this year. On top of that, technology typically performs well in inflationary periods, which is what many expect us to see in the next year or two. With its top holdings as Microsoft (MSFT), Apple (AAPL), IBM, AT&T (T), Cisco (CSCO), and Google (GOOG), technology has some major innovators and stalwarts that are key for our economic well-being. And with forward P/Es averaging about 13.5 versus a current P/E for the market at large at 16.2, they seem to be a bit undervalued.

The are, however, many negatives. For one, it seems like most pundits and investors are extremely bullish on tech and this oftentimes serves as a contrarian indicator. Likewise, in typical stock market cycles, technology leads the way at the beginning of the bull market, but only modestly outperforms six months after the recession. From a technical perspective, as you can see in the chart below, the MACD signal is showing "sell" with both the EMA-26 and EMA-9 in negative territory, often also seen as a bearish sign. In addition, the 20-day moving average just pierced through the 50-day moving average from the top (on fairly high volume as I stated earlier), which also signals a "sell." If I was going only by the technical analysis, I would be a complete bear on tech. However, I prefer to analyze the fundamentals and use that to dictate my investment choices. I am certainly not a chartist or momentum trader, although I like to point the technicals out to those who find it intriguing. Ned Davis research also points to the fact that the breadth is weakening, the seasonality trade has ended, and that production from a factory perspective for high-tech machinery remains quite weak.

Despite all these negatives, the valuation of the sector and ability of the aforementioned companies to spark an economic rally and innovation war with one another, leads me to think that XLK will be a good sector to own during 2010. Tech is always a fairly volatile industry, though, so it's certainly not for the faint of heart and is a bit riskier of a proposition than perhaps other options. (Disclosure: I picked up some XLK today, 2/4/10 with a limit order at 20.94.  Sold it on 5/11/10 at 22.93 for about a 10% gain in a bit over two months).

(Source: StockCharts.com)
Health Care

This sector will benefit from increased inflation and an aging population in the upcoming year. Although the one trump card in this sector is certainly any changes coming out of Washington, which may affect the profitability of certain areas. But such a proposal out of Congress seems unlikely at this point based on what has been passed and the proposals currently floating around that have ample support. Another pause for concern is the ending of patents for several major blockbuster drugs in the next couple years. The points that make this sector really attractive to me is its defensive nature in times of economic uncertainty, its undervaluation on an absolute basis compared to all other nine sectors (per Ned Davis Research), its ability to deliver sizable dividend yields, and the amount of cash on hand. XLV's top holdings include Johnson and Johnson (JNJ), Pfizer (PFE), Abbott Labs (ABT), Merck (MRK), Amgen (AMGN), and Bristol-Myers Squibb (BMY).

XLV is flat YTD and was up about 20% in 2009. It's 20-day MA is still above the 50-day MA signaling a bullish phase (although it's teetering), while the MACD that is a shorter-term indicator is in a slightly bearish. Not too much to glean from the technical chart, but the fundamentals to me signal a buy. XLV closed at 30.88 today.

(Source: StockCharts.com)
Utilities

Utilities as a sector is quite often defensive and boring; but that is why I like it. Its volatility isn't that great and many of the companies offer solid dividends. The demand for utilities will probably remain relatively weak given the state of the housing market, but with energy prices likely increasing and investors seeking undervalued, dividend-oriented plays, I think utilities and XLU is a solid bet for 2010. They only returned about 10% in 2009 and are down about 7% YTD, but I really expect them to be an attractive place for many risk-averse investors.

Standard & Poor's and Ned Davis Research appear to be more negative on this sector that I am, though, so I certainly will admit it if I made a wrong call. S&P argues that "an ongoing domestic economic recovery will continue to fuel cyclical outperformance at the expense of this counter-cyclical sector" which is certainly a valid stance. Utilities tend to perform best in the middle of a stock market bear, certainly not after a large upswing in the market. However, going by this same logic one would be inclined to snatch up consumer discretionary names, and I think our economic experiences in the past two years and the continued poor employment market are going to lead to a scared consumers. They certainly can sacrifice luxuries, but will continue to live and pay utility costs. Similar to S&P, NDR has a list of sector negatives such as "long-term overbought conditions," "excess capacity," "low beta," and "weaker pricing becoming a concern." However, they still have it at marketweight based on shrinking credit spreads despite the fact that valuations suggest they're not at bargain prices anymore. From a technical perspective, the signals and money flow are in a bearish phase. This sector, along with tech, are my two riskier picks.
(Source: StockCharts.com)
Energy

Commodities, and oil in particular, have had a rough couple weeks, but since I believe the global bull market will continue, I have to think that oil has some upside. Crude oil supplies are relatively high from a historical perspective, but it appears that energy is going to prove vital in many of the infrastructure projects being targeted by various governments. Emerging markets certainly will have increased demand for energy in the upcoming years (and demand in the US should have an uptick with the improved economy) and as a group, the names in the energy field are trading a bit under their valuation. The MA indicators are in the bullish phase, while the MACD is bearing as is the 3-day cash flow. XLE's largest holdings include ExxonMobil (XOM), Chevron (CVX), Schlumberger (SLB), ConocoPhillips (COP), and Occidental (OXY).

(Update 4/27/10: I would no longer own the energy sector as a result of the BP oil spill that was reported in the last few days.  As new information comes and situations change, it's important to be flexible with your investments.  You can't marry any particular position and when something disastrous like an oil spill occurs, that certainly makes the sector a huge question mark in the short-term.  I personally don't feel that the risk is appropriate to take on and would close my position.   This could be bad...really bad.  So, I'd get out personally.)

(Source: StockCharts.com)
Conclusion

In the end, we'll see at the end of this year if these were good picks or not. Certainly, I re-assess as market conditions and macroeconomic factors at play change (as they undoubtedly will), but I think these four are a good starting point and I will happily admit it if I am off-base. It will be interesting to see how these perform. On a separate note, what would I avoid in 2010? Treasuries. Gold also seems set for a pull-back after a monstrous 2009, even if that's contradictory to my above statements regarding inflation.

As I have said in previous posts, I don't think market/sector speculation and investing in non-diversified offerings is the way to go for the vast majority of investors. However, I think it's reasonable to make some gambles (and yes, they're educated gambles) with 5-10% of your assets if you have the necessary time and knowledge, and enjoy performing such trades.

Here are the closing prices as of 2/4/10 for the four aforementioned ETFs as well as a S&P 500 Index Fund. Performance will be updated sporadically and compared to the return of the S&P at large:

XLK: 20.84
XLV: 30.88
XLU: 28.99
XLE: 54.29
SPY: 106.44

Updated Performance:
 
Sector Start Price Current Price Change Through
XLK 20.84 25.19 +20.9% Year end
XLV 30.88 31.50 +2.0% Year end
XLU 28.99 31.34 +8.1% Year end
XLE 54.29 68.25 +25.7% Year end
S&P 500 106.44 125.75 +18.1% Year end



This further illustrates how hard it is to predict sectors.  The cumulative average of the four sectors was +14.2%.  However, this doesn't include dividends.  I really should like them up to make the comparison truly valid but don't have time right now.

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