Looking for Value? Consider These Two Underperforming Sectors

Stocks go up over time, but within that long-term trend there are always fluctuations. There are periods of weakness but, at least to this point in the history of the stock market, they are always followed by periods of strength that result in a regression to the mean in terms of one’s long-term return. That principle of regression to the mean is an important one for investors to understand. Most are aware of it, even if they sometimes act in those periods of weakness as if they are not. What gets talked about less, though, is that the same principle applies when it comes to sectors and industries within the market.

Sectors move in and out of favor based on the market’s perception of conditions at any one time, but give it long enough and, with hindsight, the periods of relative weakness usually look like opportunities to buy and periods of great strength like ones to sell. 

Following that principle, it stands to reason that investors should be looking for opportunities in the market’s weaker sectors right now. Stocks in general have shown strength this year as belief in a “soft landing” for the economy has grown. That has made value hard to find, and the logical areas to look for it is in the parts of the market that have fallen behind. The problem for investors, though, is that in 2023, that doesn’t narrow down their choices that much.

The S&P 500 is up just over 13% this year, but those index gains have been driven by relatively few sectors. Information technology and communications lead the way with gains of over 43%, followed by consumer discretionary with a 25% gain and industrials that are up a modest 2.8% on the year. The other seven sectors have all lost ground, led by utilities at -15% and real estate at -8%. There is a glaringly obvious reason for those two to have lost ground: they are both extremely sensitive to interest rates, which have climbed significantly this year. That doesn’t look likely to change anytime soon, so it may be a bit early to look there for value.

There are, however, two other sectors among the worst performers this year where a turnaround could come quite soon: healthcare, down 7.8%, and energy, down 6.1%. In both cases, the most likely reason for their weakness is that they are seen as “defensive” sectors of the market and have therefore been out of favor in a year marked by overall bullishness. That makes them prime candidates for those looking to benefit from a regression to the mean and there are other reasons too to believe that both will outperform in the coming months.

Healthcare as a sector has suffered because so many companies were all-in on Covid treatments and, with the pandemic over, they have been stuck with outdated vaccines and unwanted antiviral medicines. That, though, is a temporary situation. The losses associated with it have been written off and the industry has moved on to other, probably longer-lasting things like weight loss drugs and the constant stream of biologics to attack old diseases in new ways. This year has been a period of disruption and change, but people are going to keep getting sick and the industry is going to keep finding new ways of treating them, so there will be a recovery.

Energy is maybe a bit less obvious of a place to look for value.

For starters, the underperformance there follows a couple of years of significant outperformance, so it could be argued that the regression to the mean is actually what we are seeing now. However, go back further and you will see that that boom in energy followed more than a decade of extreme weakness, so this could also be just a blip in the sector’s recovery. Then there is the long-term view that the energy sector is dominated by the oil and gas industries and, given the move away from fossil fuels in the developed world, they have an at best uncertain future.

That is a more convincing argument, but we are not talking here about the next few decades, just the next few months or maybe year or two. In that time, the price of oil will be the biggest influence on the sector’s fortunes and, with supply still tight and OPEC+ determined to keep it that way, a year-end rally in crude is a distinct possibility.

Both the healthcare and energy sectors have underperformed the broader market this year and there are reasons for that. However, those reasons are temporary in nature, making those sectors ideal candidates for investors looking to use the principle of regression to the mean to find value in what otherwise looks like a fully priced market.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Markets Stocks Economy Healthcare Energy