Health Care – The S&P 500 is expected to hit 2100 by the end of this year and 2250 by the end of next year, marking a 5% to 10% increase in 2016. But which stocks can investors expect to outperform and which should be avoided? As the end of the year approaches, we’re getting a rash of recommendations from analysts.

Sales, PE to drive stock performance

Deutsche Bank strategy David Bianco and his team highlighted a long list of themes surrounding the S&P 500 in their “2016 S&P Outlook” report dated Dec. 8. Their above targets for the S&P 500 are 10% to 15% higher than history and mark the highest levels following a cyclical recovery other than in the late 1990s.

They believe that the two main performance drivers for S&P 500 companies next year will be sales growth and PE. It’s clear there just aren’t many sectors that offer both sales growth and upside to PE, but Bianco believes the Health Care sector offers a sort of safe harbor for investors worried about risk and that it will outperform next year.

He said the Health Care sector is currently the largest and fastest growing part of spending among U.S. consumers. He’s also excited about “the supply of life enhancing products and the demographic destiny of greater demand. Further, he notes that Health Care stocks are cheaper than the S&P 500, which he adds is “very unusual.” He believes the worries that have been raised recently by all the political debates about drug pricing on the presidential campaign trail have been overdone beyond Manage Care.

S&P 500 sales, EPS growth turn positive

The Deutsche Bank team expects sales and earnings per share growth in the S&P 500 will become positive next year. This year, earnings for the index are expected to come in at $119 per share, representing an increase of 0.5%. Next year, they expect a much greater growth rate of 5%, which would bring the S&P’s earnings to $125 a share. For 2017, they’re projecting an 8% increase to $135.

The main reason they expect earnings and sales growth in the S&P 500 to turn positive next year is because of an improved connection with nominal gross domestic product in the U.S. and a swing from -4% this year to +4% next year. They do expect the current foreign exchange rates to drag on next year’s sales growth by 1.5%, although that’s still much better than this year’s drag of 4%. They’re assuming that the euro averages at $1.05 next year, but if the currency only hits 95 cents, then they estimate the drag at 2.5%.

Despite these currency drags, the Deutsche Bank team expects the Consumer Discretionary, Health Care and Technology sectors to deliver sales growth of more than 5%. They expect the Industrials and Staples sectors to deliver “slight” growth and the Financials sector to see about 5% growth. They call Energy a wild card with growth potential ranging from -10% to +30% next year.

Health Care portfolio picks are important

While the firm’s analysts discuss a wide variety of themes they expect to see next year, they say picks in the Health Care sector will be next year’s “most important” equity decision in the U.S. Currently the Health Care sector is about 15.3% of the U.S. gross domestic product and about 22.4% of personal consumption expenditures. The Deutsche Bank team adds that healthcare services from professionals, hospitals and facilities are the biggest chunk but that the faster growing part of the sector is drugs, devices and equipment. They believe that growth in Health Care will remain strong because of the aging Baby Boomer population and greater efforts to develop new drugs to treat various conditions and new tools for new conveniences. They’re cautious on companies in the Managed Care and other Health Care services but expect strong growth in S&P Biotech, Pharmaceuticals, Devices, Equipment, Supplies, Tech, and Tools companies.

Because of the Health Care sector’s “record of superior growth and less cyclicality,” the analysts said it usually trades at a 10% PE premium to the S&P. As a result, the discount it is currently trading at is unusual, so they see almost four points of PE upside because they think the Health Care sector deserves a forward EPS multiple of 18 to 20 times or a trailing multiple of about 20 times – if the 10-year Treasury bond yield doesn’t “significantly exceed 3.5% this cycle.” At this time, the Health Care sector has a multiple of 16 times forward PE, lagging the S&P’s multiple of 16.7 times.

They add that investors should “be offensive with defensives” heavily overweight on Health Care and also Utilities.

Health Care valuation similar to 1993

The Deutsche Bank team does add that the current discount on the Health Care sector is understandable given the debates that are ongoing on the presidential campaign trail. They compare the current state of the sector to its state in 1993 during the “worst of the Hillary Care sell-off.”

S&P 500 Health Care

S&P 500 Health Care

“Back then a 14 PE with 6-7% 10yr treasury yields was as or more demanding than a 16 trailing PE today with 10yr Treasury yields under 2.5%,” the analysts wrote. “So valuations are similar now, but in 1993 Democrats held a majority in Congress. When Republicans took Congress in 1994 Health Care stocks soared. Today, Republicans control congress.”

Deutsche Bank analysts expect sales growth of more than 6% and earnings per share growth of more than 7% from the sector next year and note that it has the best revision trends for both revenue and earnings of any of the major sectors.

S&P 500 Health Care

Wait on Energy stocks

Interestingly, Bianco and his team discounted the thesis on the Energy sector set forth by JPMorgan analysts, who upgraded it this week because they think that by the end of next year, things should be looking up for it. Deutsche Bank called Energy stocks a “value trap” and believes the expected recovery in oil prices will disappoint investors next year, while JPMorgan believes the high dispersion rate in the Energy sector sets up a stock picker’s dream scenario.

Here’s a look at their recommendations of weightings by sector:

S&P 500 Health Care

All graphs in this article are courtesy Deutsche Bank.