Three stock market themes to play in the third quarter

Published Mon, Jul 4 20228:19 AM EDTUpdated Mon, Jul 4 20228:55 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The health care sector is often a sleepy performer but in this market turmoil it may prove to be one of the areas of not only safety in the third quarter — but growth. The third quarter could be a turbulent time, after the worst first half for stocks since 1970. As investors fear rampant inflation and a heavy handed Federal Reserve, they are looking for places that could still generate some gains and income. The steady earnings power and dividend quality of some health care companies may be a welcome hideout for investors. The broad health care sector is one of three investment ideas picked by analysts for outperformance during the summer months. The others were bank stocks and companies that generate a great deal of free cash flow but are unloved in that investors have been shorting them. According to CFRA, the health care sector and biotech industry have traditionally outperformed in the third quarter of a mid-term election year. Despite regulatory concerns, the sector has been an island in what is usually a stormy quarter. The S & P health care sector this year has outperformed the S & P 500, which lost nearly 21% in the first half. In the same period, health care declined just 9%. For the second quarter, the Health Care Select Sector SPDR Fund, representing the S & P health care sector, declined 6.4%, while the S & P 500 dropped 16.4%. Health care, on a historic basis, was the best performing major sector in the third quarter period in years when there was a mid-term election. Going back to 1990, the sector itself was up 4.4% in those quarters, compared with the S & P 500's average decline of 1.8%. CFRA data also shows that among S & P subsectors, the best performing was tobacco, up 6.4% in the third quarter of mid-term years. But all other positive subsectors were in the health care sector. That includes health care facilities, up 6%; pharmaceuticals, up 5.1%; health care equipment, up 2.1%; health care distributors, up 2% and supplies, up 1.8%. Get ready for the third quarter Navigating the third quarter after 2022′s rough start Top Wall Street strategists see the stock market recouping most of its losses into the year-end These stocks have major upside heading into the second half, Wall Street analysts say Sam Stovall, CFRA chief investment strategist, identified some companies in those health care subsectors that investors may want to consider. They include HCA Holdings; Pfizer; Tandem Diabetes Care ; Patterson Cos.; Align Technology and Walgreens Boots Alliance. David Bianco, chief investment officer of the Americas at DWS Group, said he also sees opportunities in health care, and he is most overweight the sector in his DWS Sector Strategy Fund. "We think it's growth at a reasonable price, not at risk from higher interest rates," he said. "That includes pharma and biotechs." Biotech has been beaten down with high growth names , and both Stovall and Bianco say it's time to give it a look. The iShares Biotechnology ETF has been moving off its low, but it is still well below its 52-week high of $177.37 per share. Bianco said names he is overweighting in the biotech sector include Abbvie and Amgen . In the most recent CNBC Delivering Alpha survey, 58% of investors said health care should be among the biggest winners at the end of 2022. CNBC surveyed about 500 chief investment officers, equity strategists, portfolio managers and CNBC contributors who manage money, in a survey this past week. Energy topped the list with 68% expecting it to be one of the best performers, and third was financials with 34% expecting the sector to do very well. Banks aren't the culprits this time Bianco is one of those who favors certain financials, and he expects bank stocks could do very well later this year. He likes the major banks JPMorgan , Wells Fargo, Bank of America , Citigroup as well as PNC Financial . "Their profitability is driven by short-term interest rates, not the shape of the yield curve," said Bianco. He said if there is a recession, it will not because of banks, unlike 2008. "We don't expect a credit crisis to come of this." In addition to banks, he likes insurers, like Chubb and Marsh & McLennan. When in doubt, look for cash flow Julian Emanuel, head of Evercore ISI equity, derivatives and quantitative strategy, said he is looking across all sectors for stocks with traits that could help them weather both inflation and a weak economy, but also outperform. First, the companies have to generate a lot of free cash flow, and they should be stocks that are widely shorted. "It's been said that cash is a liability in a high inflation environment. Not only do we disagree, but we disagree vehemently. We want stocks that throw off a lot of cash, and we want stocks that people continue to short the whole way down," he said. Emanuel created a list of companies that fit his criteria with a market capitalization of more than $5 billion. He also picked companies that did not make a new low in June, unlike the S & P 500. The list included a mix of sectors. Energy names on the list were among the highest generators of free cash flow. Occidental Petroleum , for instance, is expected to have free cash flow of 25.5% and Ovinitiv is expected to be at 24.7%, according to Evercore estimates. Consumer discretionary names also made the list. Dick's Sporting Goods is estimated to have free cash flow of 16.3%, and luxury retailer Capri Holdings , 12.7%. Capri owns the Jimmy Choo and Michael Kors brands, among others. Also on the list was Omega Healthcare, with free cash flow estimated at 12.3%. The REIT works with assisted living facilities.