The stock market delivered strong returns in 2024, gaining 23% and recording two consecutive years of more than 20% returns.
That’s pretty impressive, considering the S&P 500’s historical average annual return is closer to 10%. But those returns reflect gains in a wide range of stocks, crossing different parts of the market. It is interesting that some sectors achieved even higher returns, writes The Street.
For example, those who were smart enough to look past the skeptics and stash money in the tech sector were particularly well rewarded. The iShares Technology ETF (XLK) has returned a whopping 30.25% in 2024.
Of course, the past doesn’t guarantee the future, so investors are right to wonder if the technology can continue on its winning ways, or if there’s somewhere else they can better anchor their hard-earned cash.
American investment bank Goldman Sachs has just revealed its favorite sectors that will have a special weight in 2025, making it easier to decide whether to stay put or switch to other baskets.
Goldman Sachs’ research team recently launched a sector model for US stocks, which recommends “high conviction” overweights based on the likelihood that an equal-weighted sector will outperform the equal-weighted S&P 500 by five percentage points or more over the next six months.
His model typically suggests that three sectors should be overweight over the next six months.
So far, the results of the model are intriguing. The last test showed it has outperformed the S&P 500 by a 6-month average of 8% since 2004.
Of course, this testing assumes perfect prediction of model inputs, such as macroeconomic variables, including economic growth, reports Investor me. Still, those are robust returns.
Goldman Sachs’ 2025 sector overweights could similarly deliver gains, but Goldman admits there are challenges in predicting this year’s likely winners. A lot could depend on economic growth.
The bank’s economists forecast “above trend and consensus US economic growth, which, along with potential changes in fiscal policy, generally supports a cyclical stance.”
However, they also expect economic growth to slow slightly, and stocks are likely already priced in against a very bullish growth backdrop. After all, stocks aren’t cheap after the past two years of outsized returns.
What do the prospects say for this year?
As part of its analysis, the Goldman team provided its outlook for a range of different macroeconomic data. Goldman Sachs’ sector model includes:
Macro data: economic growth, unemployment, interest rates, trade-weighted US dollar and oil prices.
Basic data: Consensus earnings growth, profit margins and return on capital.
Valuation: Price to Earnings (P/E), Price to Book (P/B), Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA) and Enterprise Value to Sales (EV/Sales).
Based on all the various inputs, Goldman Sachs analysts recommend that the following sectors be preferred in portfolios:
– Materials;
– Software and services;
– Health care;
– Utility sector;
– Real estate.
The model choices with the highest conviction of the five are Materials and Software and Services. Note that the sector model separates the information technology and communications services sectors into their different industry groups to better reflect the different businesses. The sample period used includes 2004-2018.
In 2024, the S&P 500 iShares Basic Materials ETF ( XLB ) produced a negative return of 4.53% versus a positive 23% for the S&P 500. The S&P 500 Basic Materials sector ended last year with a forward 12-month price-to-earnings, or P/ E, at the level of 18.3x compared to the 20-year average of 15.2x.
However, looking ahead, Goldman Sachs predicts that the sector: 1) should generate EPS growth of 13% in both 2025 and 2026; 2) currently trading at an 8% discount to the S&P 500; and 3) looking back over the past 20 years, the estimate for the sector is only in the 18% percentile. The three largest stocks by market capitalization in the sector are Lin plc (21.5%), Sherwin Williams (8.3%) and Air Products & Chemicals Inc. (6.8%).
Software focused on AI
On the software side, the iShares Technology Software ETF ( IGV ) (using this as a proxy for software firms) returned 23.41% in 2024.
Within software stocks last year, there was a fairly wide range of dispersion between winners and losers. While valuations for software stocks are currently on the high side (note: software currently trades at a 68% premium to the S&P 500 and is in the 90% percentile looking back 20 years), Goldman Sachs points out that: 1) Currently forecasts industry EPS to grow 10% and 14% in 2025 and 2026; 2) the group has a long-term estimated growth rate of 14% and 3) the sector currently boasts the highest return on equity (31%) and net margin (28%) of any S&P 500 sector.
Growth and spending on AI is likely to fuel additional gains in several software stocks in the coming year.
Many of the largest software and communications stocks, such as Microsoft Corp, ServiceNow Inc, Salesforce Inc., Adobe Inc. and Oracle Corp, along with names like Meta Platforms and Netflix Inc, are already spending significant amounts of money on AI. Artificial intelligence trends are likely to continue to favor a wide range of software and communications this year.
According to a recent industry forecast by International Data Corporation – IDC, “the rapid incorporation of artificial intelligence, and particularly generative artificial intelligence (GenAI) into a wide range of products will result in a compound annual growth rate (CAGR) of 29.0% during the forecast period 2024-2028.”
