Can Tech and Oil Stocks Continue to Outperform?

The first half of this year is like the tale of many cities. The S&P 500 is up close to 4%, the trade-sensitive Dow Jones industrial average is up less than 1% and the tech-heavy Nasdaq is soaring, topping 12%.

Small-caps have outperformed large-caps, cyclical sectors are besting staples and tech, consumer discretionary and energy stocks have led — the first two up about 10% each and energy about 6% higher.

Moreover, within the top performing sectors, sub-industries like internet and direct marketing retail under consumer discretionary, which include stocks like Netflix and Amazon, rose almost 50% while application software gained 30%.

So far so good, but what happens next given the backdrop of an escalating trade war between the U.S. and China, expectations for two additional rate hikes by the Federal Reserve and upcoming midterm elections, which could be among the most pivotal in decades?

Sam Stovall, chief investment strategist at CFRA, expects the S&P 500 will reach 2,845 by year-end, which is 2.5% above Wednesday’s price at midday, and 3,000 over the next 12 months, according to a recent CFRA webcast. He expects volatility will increase in the third quarter — it tends to rise 34% in the third quarter of an election year — and small-cap stocks will continue to outperform large-caps for several reasons:

• They underperformed last year and can therefore revert to the mean
• Their average price-to-earnings ratios are currently about 8% below their long-term average over the past 20 years
• Small-caps are the primary beneficiaries of tax reform because their revenues are mostly based in the U.S.
• Small-caps, as a result, are more insulated from the negative impact of a trade war

CFRA is overweight small-caps. It’s also overweight technology and energy, having upgraded from market weight in early May, as well as industrials, which has been the third worst performing sector year to date, according to CFRA Strategist Lindsey Bell. Its list of favored tech stocks is diversified and include Alphabet (GOOGL), Oracle (ORC), Broadcom (AVG) and Fitbit (FIT).