Denise Chisholm is a sector strategist and research analyst for Fidelity Management & Research Company, the investment advisor for Fidelity’s family of ETFs and mutual funds. She is responsible for the research of portfolio construction strategies combining sector-based mutual funds and ETFs. Chisholm also has a unique way of analyzing sectors using historical data and probabilities. ETF.com caught up with her to talk about sectors, particularly financials, as we head into next week’s Fed meeting, where the consensus is for an interest rate hike.
ETF.com: You analyze sectors using historical data. How is that different from the way others do it?
Denise Chisholm: I have a different process than most people who analyze sectors. They stand in two camps, one being a fundamental camp and the other being a more macroeconomic camp. What you find historically is that a lot of the fundamental factors don't work as well in sectors.
The approach I've chosen is to use historical data. That's mainly to layer the probabilities associated with historical data, both our internal fundamental data sets, and our macroeconomic data to integrate cycles or specific trends within sectors. I layer historical probabilities to allow history to inform my views.
ETF.com: What are some of your sector recommendations at this point in the year?
Chisholm: Let's talk about financials first because it’s not only a recommendation, but it's one of the most unique sectors historically. Most investors I talk to, both internally and externally, are reticent to buy financials since it's outperformed so much. But again, we can use history to inform our views.
If I say I'm going to base my probabilities of future performance on my conditional probabilities of past performance, you basically get 50/50 odds for outperformance in every sector but financials, where you're looking at like 62% odds.
And if I take out the times when we know there were head-fakes, it doesn't change probabilities for any other sector; they still retain 50/50 odds, but financials go to 69%.
And if you tell me further, “Well, it's different this time; they're up a lot, well beyond their historical average of just random outperformance,” I would tell you that actually increases the probabilities that they outperform more.
ETF.com: That's counterintuitive to a lot of the way people think about investments—let me go find that worst-performing one, because it's got value.
Chisholm: That's exactly right; it is counterintuitive, but history shows this happens quite often, which is, again, not to say that it has to happen this time, but we should be conscious as investors of what that means. I always say that statistically you have to chase, which is a little bit of a nice catchphrase for people to remember.
The second thing that's really unique about financials is that, when they outperform, other cyclicals tend not to keep up. They don't offer the high odds or high alpha, on average. But over any one-year time frame, financials tends to dwarf other cyclical bets.
Ironically, the sector that actually outperforms in tandem with financials more often than not is consumer staples.
ETF.com: Why is that?
Chisholm: When financials work, they tend to be the only game in town, on a cyclical basis. Consumer staples is a little less defensive than the defensive sectors, but participates as well.
ETF.com: And on the other side of the coin, give me a sector that is falling out of favor in your analysis.
Chisholm: I'd say utilities, which is usually the counteropposite in terms of correlations between financials. When I look at the defensive sectors historically, consumer staples and health care have many things going for them. This is sort of a broad brush, but I’d say they have 80% odds of outperforming in a down market, and they have above a 50/50 chance of outperforming in an up market, meaning, they have some cyclical tendencies.
For health care, we can talk about what we've seen, which is their advantage from a multiple standpoint, and you haven't seen any margin decline yet.
For consumer staples, you're actually seeing a turn in margins because capex relative to sales has been so contained. They actually have some offensive characteristics as well.
Utilities, however, is the other side of the ledger. Where they'll outperform, let's call it 80% of the time in a down market, they’d only outperform 35% of the time in an up market. It’s sort of the negative correlation. They tend much more so than staples and health care to not outperform when profits accelerate, which is the base case going forward for all the reasons we described.
And for all our focus on rising interest rates, which is the only framework we need to know from an investment perspective, from a sector perspective it's not really great at determining odds. It’s not the significant factor historically, but it is specifically a negative factor for utilities. It changes your odds of outperformance from about 47% to something like 32%, which is not 0% odds, but it's pretty low.
ETF.com: In that same vein, when it comes to financials, the narrative is that rising rates are good for the financials sector because it improves its lending spreads. Is that something you consider?
Chisholm: I have heard the statement that interest rates are significant for financials and that's the play. When you look historically, on average, rising rates actually decrease your odds [of outperformance], marginally. It hasn’t been a significant positive factor historically for financials.
There are three critical drivers to financials' relative performance. The first is what everybody says: net interest margins. That's the spread between short- and long-term interest rates. Essentially short rates rising usually means a steepening yield curve; therefore, net interest margins expand. If you get that right, that'll give you about 60% chance of getting the financial sector right. So it’s a positive, but it's not a lock.
The second thing that's more important than that is loan growth. And the Trump administration and financial deregulation could impact that. Banks are more willing to lend. If willingness to lend goes up—we can study it historically—you have 71% odds of loan growth acceleration regardless of the base rate, which is an inflection from here, and we're at about average loan growth. If you get loan growth right, you have about 70% odds of getting the financial sector right. That's positive.
The final thing that trumps everything else in financials, especially when it's going bad, is credit. That's what we've seen over the last two years. Net interest margins have compressed, the short end has stayed down, and that was a negative. Loan growth accelerated, but not to great rates; so that was a loose positive. But credit has deteriorated, until now, for about 18 months. That overwhelmed the financials and compressed their multiples more than relative earnings offset it. On a go-forward basis, that's the factor that changes the most.
So if you say, “What if your base case plays out and profits recover? What are the odds that credit deteriorates?” Your odds are 10%.
Most likely, credit actually improves off of pretty decent levels. If credit improves, loan growth accelerates, and net interest margins expand, and you have the trifecta [for financials]. And it's shifting from an area where none of those have been particularly positive over the last 18 months to all three of them being positive, potentially, going forward.
ETF.com: Deregulation can be a more powerful fuel for credit growth, mitigating what higher interest rates might be. Again, the intuitive thought is, higher interest rates will mean less loan growth because lending will get more expensive.
Chisholm: I would say that not only does it mitigate it, but they're correlated. If I tell you profits are going to recover, almost by definition I'd tell you that odds are that interest rates rise. The interesting thing about interest rates rising is that when they do, so does GDP growth. And so does investment spending.
All these things are correlated, which, for me, leads me to the conclusion that interest rates are more often than not a function of growth, not a deterrent to growth. Now, of course we can point out the obvious examples where they were a massive deterrent to growth in the '80s. But more often than not, you see lending accelerate along with interest rates.
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