Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch, you looked at the best-performing sector this year for the S&P 500, which has been Health Care. How much better was it over the other sectors thus far this year?
Stovall: As of Tuesday, December 16, the price performance for Health Care is up 21% versus the S&P 500’s 6.7%. The second best performing sector is Utilities, which is up 18.7%. So Health Care has really done the best by far over most of the other sectors.
EQ: Biotech certainly has been the hottest and most talked about group within the sector, but what are some other industry groups that enjoyed their own sizeable gains this year?
Stovall: If we look to some of the biggest gains, Biotech has certainly done exceptionally well, being up over 30%. Other sectors that have been up over 20% include Health Care Equipment (medical devices), which is up over 22%, and Managed Health Care –or in other words HMO—which is up close to 30%. Even Health Care Facilities, which are your hospitals, are up more than 30%. So there have been several groups that have done very well. Really, only the Life Sciences Tools and Services group was in the single digits, but at least they were all in positive territory.
EQ: One of the reasons you looked at Health Care was because of this theme you’ve talk about where you let your winners ride. You looked at fundamentals and technical indicators for Health Care, and they all seemed promising. Which specific ones did you look at and why?
Stovall: Well, because Health Care not only did well last year but has also posted a compound annual growth rate of 17%, which is much stronger than the 12.5% by the S&P 500, some investors may be thinking that they should be lightening up on this sector. Our feeling is you’re better off letting your winners ride. Granted, we are seeing the valuations for Health Care become less and less compelling than they were a few years back. However, we don’t think that they are off-putting.
First off, Health Care will likely report earnings increases of 15% for this year versus the 7% for the S&P 500, and they are expected to post increases of 12% in 2015 versus 8% for the S&P 500. So good earnings growth is anticipated for the year ahead.
I also looked at the relative P/E ratio for the Health Care sector, which is the P/E of the sector versus that of the S&P 500. I also tracked the movement since 1995 and its near 20-year average. Right now, it’s at about a 12% premium to the S&P 500’s valuation.
At first, you may think that’s expensive, but that’s smack even with the long-term average. So while it’s loftier than it was in the latter part of 2009, it is still well cheaper than it was during most of the 1990s.
EQ: What are some potential challenges for the sector in the coming year? Which sub-industry groups could be hit the hardest?
Stovall: One of the concerns is if the earnings don’t come in as expected. If that happens, then obviously the valuations, which are now in line with long-term averages, are not justified. Some other things that could be of concern are that state governments and third-party payers continue to try to contain and lower costs—also known as reimbursements. If they try to reduce those, then the companies continue to get paid less and less for their services. So that would be a problem.
Now that the Republicans have taken total control of Congress, some investors are concerned that they are going to try to ram through some eliminations of the Affordable Care Act. We don’t think that’s going to be a possibility, but they probably could chip away at some unpopular parts of the ACA, specifically as it relates to taxes. Some targets could be the medical device tax, the health insurer’s fee, the employer mandate, etc.
But what we tell investors is that if they get rid of one tax, then they are probably going to have to raise taxes somewhere else to make up for the shortfall. So it will probably end up being a zero-sum gain.
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