Our 2021 Look Ahead Survey showed that the DataTrek community is most bullish on Technology and Energy, so we’ll take a deeper look at those 2 groups today. In many ways they could not be more different, as the following 2 points highlight.
Point #1: Current and future fundamentals, Wall Street opinions:
Current net profit margins (Tech fantastic, Energy horrible):
- Technology’s Q3 2020 net margins were the highest of any non-Real Estate Investment Trust (which pays no corporate taxes) sector. The group had a 22.1 percent net operating margin, and that was actually UP from last year’s Q3 of 21.6 percent.
Both results are more than double the S&P 500’s aggregate net margins of 10.9/11.4 percent for Q3 2020/Q3 2019.
- Energy was the only S&P 500 sector to post an aggregate net income loss in Q3 2020. In Q3 2019, Energy’s net operating margin was just 5.4 percent.
That means that even when it was profitable back in 2019, Energy’s net margins were half the S&P 500’s as a whole.
Future earnings (Tech grinds higher, Energy rebounds sharply):
- Analysts expect Technology to post 8.3 percent revenue growth next year, which will translate into 14.4 percent earnings growth.
That means Wall Street is looking for Tech to do slightly better on the top line than the S&P 500 as a whole (7.9 percent growth expected) but worse than the index in terms of earnings growth (21.9 percent growth expected).
- Energy sector analysts expect the group to show 15.4 percent revenue growth next year, the best of any S&P sector. This should be sufficient to bring the group back to profitability after a loss-making 2020.
Valuations (Tech expensive as always, Energy in line with the S&P 500):
- Tech trades for 26.7x forward 12-month earnings
- Energy trades for 21.7x forward 12-month earnings
- The S&P trades for 21.9x forward 12-month earnings
Price targets (Wall Street thinks Tech has more upside):
- If you bundle up all of Wall Street’s price targets and work out the S&P 500 price level that implies, the index has 9.1 percent upside over the next 12 months.
- Do the same math using Tech sector analysts’ price targets and you get 8.9 percent upside for this group over the next 12 months.
- The same math using Energy sector analysts’ price targets gets you implied upside of just 2.0 percent over the next 12 months.
Takeaway (1): Tech’s fundamentals and near-term outlook is classic “quality growth”. Huge, defensible margins. Strong incremental cash flow off an already high base.
Takeaway (2): Energy is classic “cyclical turnaround”. High fixed costs generate huge losses in a downturn and significant operating leverage in an upturn. In this case, there’s a potential 2-fer effect of higher commodity prices and volumes.
Takeaway (3): it is therefore easier to argue that Energy is “cheap”. We can be pretty sure Wall Street analysts have their Tech sector estimates fairly close to right because 2020’s results give them a solid Year 1 base on which to build their 2021 financial models. That’s not the case for Energy, where pricing/volume leverage is harder to call. The only thing that really moves stock prices permanently is changes to earnings expectations, and Energy has more potential to show that in 2021 than Tech.
Point #2: Since we’re talking about potentially overweighting either Technology or Energy in a diversified portfolio, we should also look at the correlations of each sector to the S&P 500. Again, they really could not be more different.
Here is the trailing 90-day rolling correlation of daily returns between the S&P large cap Energy sector and the S&P 500 from 1999 to the Present:
Two points here:
- The average correlation across this 20-year timeframe is 0.64. That works out to an r-squared of just 41 percent, much lower than the typical 50% level of other groups across business/market cycles.
- The chart shows why this average correlation is so low: for all the times Energy behaves like a “normal” sector (2009 – 2015, middle-right of the chart), it can also entirely decouple from general equity market action.
Now, here is the same correlation data for the large cap Technology sector relative to the S&P 500 (also 1999 – Present):
Two points here:
- The average correlation here is much higher, at 0.89. That makes for an r-squared of 79%, which given Tech’s market-leadership status makes sense.
- Tech’s correlation to the S&P 500 never breaks down the way Energy’s does. The low water marks here are 0.70, not negative or just 0.20, as is visible on the first chart we showed you.
Takeaway: to our thinking, this correlation data speaks to how large an overweight one might want to consider in either Technology or Energy. Given Tech’s general tendency to correlate strongly with the S&P 500, one has to be careful with position size. While there may be periods when Tech zigs and the market zags, they are rare. Conversely, Energy is one of those sectors where under- and over-weighting can deliver good results with only modest position sizing. A little can go a long way.
One last point before wrapping up: don’t forget that Tech is the largest sector in the S&P 500 at 27 percent of the index and Energy is basically the smallest (ex-REITs) at 2.5 percent.
Summing up: readers know we favor cyclicals at the moment, so no surprise that we do like Energy here. While it has perhaps run too far/too fast (+38 percent since October 30th), it does have the ability to show significant operating leverage in 2021. Technology may not be as attractive on that basis, but we have liked the group since starting DataTrek for more secular than cyclical reasons. That sentiment has not changed. In the end, we like both sectors (just as clients do), but for different reasons.