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The Best Stock Market Sectors in 2018

Debbie Carlson

Information technology, materials and consumer discretionary were among the best-performing sectors in 2017, and at least two of the three may continue to rise in the first part of 2018, market watchers say. But any new year brings potential for different sectors to shine.

That may especially be true in 2018, when the actual winners and losers from tax reform should become apparent. At the same time, as investors rebalance their portfolios in January, market watchers caution that the current bull market's age and the outlook for monetary policy may inhibit stock market returns this year.

[See: 7 ETFs to Profit From Recent Tax Cuts.]

The bull market, which dates to March 2009, is in its mid-to-late stage of life, says Juliet Ellis, chief investment officer at Invesco's US Growth Equities in Houston, in a research note. Returns at this part of the cycle usually average between 6 and 9 percent, she says, versus the 19 percent the Standard & Poor's 500 index returned in 2017.

Invesco expects high-single-digit growth overall for stocks, she says. That forecast is based on a 2 percent real gross domestic product, mid-single-digit earnings growth plus a 2 percent dividend yield. "The biggest risk to this view is a change in leadership at the Federal Reserve that would result in monetary policy tightening too quickly," she says. Federal Reserve board member Jerome Powell will replace Fed Chair Janet Yellen, whose term expires in early February.

Late-stage winners. As the bull market and economic expansion grow long in the tooth, investors may want to consider sectors that tend to bloom late in the game. For example, after lagging last year, energy could perk up from continued global growth, says Jeff Kravetz, regional investment director for U.S. Bank Private Wealth Management in Scottsdale, Arizona.

Lindsey Bell, investment strategist at CFRA Research in New York, says her firm likes industrials and materials because they're tied to the current strong economic cycle in the U.S. and globally. "These sectors usually do well at the end of bull markets," she says. Additionally, based on historic seasonal patterns, this time of year also benefits industrials and materials, as these two sectors often perform well from November to April, she says.

Bell also cited the consumer discretionary sector as one that performs well in a late-stage bull market. Kravetz also likes consumer discretionary, but selectively. This sector has done well because of increasing consumer confidence, he says, but "it's really a case of haves and have nots in that sector," he says. "It takes more skill to sort out the winners and losers."

Retailers are a perfect example. Like other consumer discretionary stocks, retailers tend to benefit from consumers who are willing to spend thanks to the wealth effect of a record-high stock market and a booming economy. Successful retailers today, however, usually fall into one of two camps: Those that are tied to e-commerce, or traditional retailers that successfully lure customers into stores by offering product samples, services, or goods that consumers want to see in person before buying, Kravetz says.

In fact, the huge shifts technology created are still sorting out the winners and losers for consumer discretionary companies, Ellis says. E-commerce is part of a long-term secular growth story, she says, noting that only about 10 percent of U.S. commerce currently takes place online. "We believe this will grow to 30 percent or more of total retail," Ellis says. "Food and food service, autos and auto parts, furniture, appliances, and luxury goods have yet to see significant online penetration."

[See: 8 Luxury Retail Stocks Worth a Look.]

The elephant in the room. No story about winning sectors in 2018 is complete without mentioning which ones should gain from tax reform.

Financials should do well in 2018, Bell says, as this sector stands to benefit from the recently passed tax legislation. While changes in corporate and individual tax codes have both positive and negative implications for the profitability and asset risks of U.S. banks, overall the new tax law is a plus for bank creditworthiness, according to a Moody's research note. Moody's analysts say higher profits will likely benefit shareholders in the form of rising dividends or share buybacks. Meanwhile, the lower tax burden should mean a bank's capital is better protected if the cost of credit or other expenses rise.

Growth estimates for 2018 increased for financial companies, one of the few sectors with higher estimates this year, Bell says. Those estimates, she says, rose to 15.2 percent from the June 30 estimate of 13.4 percent. That compares to estimates for the S&P 500's 2018 growth rate, which contracted by 150 basis points over the same period. "We like [the sector] because of domestic dominance, and valuations have also returned to historical levels [to] become more attractive," she says.

Bell and Kravetz also flagged health care as a sector that should continue doing well in 2018; health care outpaced the broader S&P 500 index in 2017. "Health care is one of these perennial sectors we like," Kravetz says because it has both defensive and growth-oriented qualities. "On the growth side, it has a lot of innovation, be it devices or drugs. It is defensive because it's a sector that everyone needs," he says, adding that health care is "a good all-weather sector."

Technology is also changing health care in ways that could have long-term ramifications, Invesco's Ellis says. "Big data, super-computing power, robotics, miniaturization and genome mapping are driving innovation in pharmaceuticals, biotechnology and health care devices."

Politics has been another factor for health care investors over the past year. Bell says CFRA has been overweight in health care since August and continues to maintain that stance, despite last year's uncertainty over whether the Affordable Care Act would be repealed. Although a Republican Congress failed to repeal the act, the new tax law could hurt some health care companies.

[See: 7 of the Best Health Care Stocks to Buy for 2018.]

Moody's cautions investors to beware of health care companies that have high leverage or are part of some significant leveraged buyout activity. By limiting how interest can be deducted, the new tax code will hurt speculative-grade companies that took on a lot of debt to lower interest costs.

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.