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Don't Buy The S&P 500, Buy These 3 Sectors Instead

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Don't Buy The S&P 500, Buy These 3 Sectors Instead

Last week, the August CPI (Consumer Price Index) broke out of its downward trend that began in September 2022. The CPI came in at 3.7% year-over-year, missing expectations.

This expectations miss was primarily driven by two factors. First, there was a spike in energy prices, which increased by 5.6% in August alone due to a significant rise in gasoline prices. Secondly, there was a lag in shelter inflation, which remains at 7.3% YoY despite stable rent prices.

While shelter CPI is expected to decline over time, energy prices are less predictable. The recent extension of production cuts by Russia and Saudi Arabia, coupled with the steady uptrend in oil prices, indicates a potential for more inflation in gasoline prices in the coming months.

GDP growth remains strong at 2.1% in Q2 2023, which poses a challenge for the Federal Reserve. The Fed has emphasized the need for a period of below-trend growth to curb inflation, but that hasn’t materialized yet.

This week, the Federal Reserve paused rate hikes but raised its interest rate forecast for next year from a median of 4.6% to 5.1%. The Fed’s stance remains hawkish due to concerns of accelerated inflation driven by robust economic growth and rising energy prices.

Interest Rate Expectations and Implications for Investing in the S&P 500

In previous discussions about the S&P 500 (NYSEARCA:SPY), the focus has been on its high P/E (Price-to-Earnings) multiple, historically translating into subpar annual returns of around 5%. REITs (Real Estate Investment Trusts) were recommended as a viable alternative.

Today, it is crucial to delve deeper into multiple inflation and interest rate scenarios to identify the best sectors for investment based on historical data.

Zooming out from recent trends, the S&P 500 (SPX), Nasdaq (NDX), and Dow Jones (DJI) have primarily been influenced by interest rate expectations. Therefore, two scenarios need careful evaluation:

Scenario #1: The Market Expects Decreased Interest Rates in 2024

The market currently foresees a reduction of 75-100 basis points in interest rates throughout 2024. This outcome depends on either a soft landing or a scenario where economic growth slows down, unemployment rises, and a recession occurs.

While both outcomes are possible, the market has already priced in this bullish scenario, resulting in lower expected future returns. J.P. Morgan estimates that the S&P 500’s total returns over the next five years will be below 5% per year, indicating unfavorable risk-reward ratios.

To potentially outperform the index, investors may choose undervalued companies poised to benefit from interest rate drops. REITs and Financials are favorable sectors in this regard, although a comprehensive risk assessment is essential before investing.

Scenario #2: The Market Is Wrong, and Interest Rates Will Remain High for Longer

Current high interest rates reflect concerns about inflation and strong economic growth. Assuming a prolonged higher-rate scenario implies expectations of continued high inflation and a reasonably healthy economy.

This riskier scenario presents two challenges. Firstly, high inflation tends to decrease P/E multiples. Secondly, the market faces potential downside risks attributable to the current elevated index multiples if the anticipated rate cuts do not materialize.

A study by Hartford Funds reveals that in a high inflation environment, Energy and Equity REITs have consistently outpaced inflation (75% and 65% of the time, respectively) over the past 50 years.

Furthermore, the study shows significant outperformance, with average annual inflation-adjusted returns of around 10% for energy and 5% for Equity REITs. Notably, Mortgage REITs have performed poorly in such environments.

The significant role of energy in driving inflation makes it an intuitively logical sector to invest in. As for REITs, their performance might not be immediately apparent due to rising interest rates. However, once rates stabilize, many REITs can increase their rents substantially, offsetting any interest expense increases.

A Cohen & Steers analysis indicates that REITs historically deliver double-digit (nominal) returns during periods of high inflation, regardless of the specific interest rate level. After reaching peak rates, REITs have returned an average of 21.4% over the following 12 months, more than double the broader stock market’s performance.

Conclusion

While the future direction of interest rates remains uncertain, investing in the index does not seem attractive at present. Lower rates would likely result in lower returns, and if the market is incorrect about extended higher rates, significant downside risks could arise.

However, opportunities exist in Equity REITs and Financials, which currently trade at historically low valuations and are well-positioned to outperform the index in Scenario #1. Under the higher-for-longer scenario, Energy and Equity REITs stand out as top contenders with substantial potential for outperformance.

Investing in these three sectors could prove rewarding.