The two-month equity surge that started off the New Year has lifted virtually all of the marina. But looking back a bit further in time shows that not all shares have been rallying.

In a study prepared by MSCI for Financial Advisor, the global data miner revealed that trailing-one-year returns through February 21, 2012, have been all over the place. Despite current bullishness, average market return over the past 12 months was a modest 3.76%.

But certain sectors have been leading the market forward. Three years since the market bottomed in March 2009, it's surprising to see that defensive stocks have been the top performers over the past 12 months.

Total returns of U.S. utility shares were up 14.28%. Consumer staple shares ranked second, having risen a robust 13.61%. And health-care stocks followed with average gains of nearly 12%.¹

Within this parade of defensive shares, cyclical consumer discretionary and information technology shares came in fourth and fifth, up 8.67% and 8.34%, respectively. Despite last year's volatility, the performance of these growth-oriented sectors has reflected the shift in market sentiment from cautious recovery to expansion.

Remnants of the financial crisis, however, are still evident. Financial shares have been the worst drag on the market, having lost 11.71% over the last 12 months. And two key growth-sensitive sectors, materials and industrials, were the second and third worst-performing shares, having declined 2.25% and 0.16%, respectively. This suggests that so far consumers, not manufacturers, have been leading the recovery.

The MSCI study also revealed that global returns-measured in U.S. dollars-have in a number of cases been very different from U.S. returns.

All developed markets (MSCI World Index) and developed plus emerging markets (MSCI All Country World Index) underperformed domestic shares by around 5.7% over the past year. The difference would've been even greater had the U.S. dollar not appreciated over that time. Using the euro as a foreign currency proxy, the dollar had gained 3.91% in value, which boosted the value of foreign equities (at least those denominated in euros) by the same amount.

The largest performance gap between the U.S. and global indices was seen in utility shares. Both developed and all-country indices underperformed U.S. utilities by around 20% over the past year. According to Jennifer Bender, vice president of research at MSCI, this huge gap was the direct result of Japan's nuclear disaster. "Regulatory response to Fukushima was far more aggressive in Europe and Asia than it was in the States," she explained, "hitting foreign utility shares much harder."

For telecom services and materials, the differential was around 8%. The gap for consumer staples was around 6.5%, and for IT it ranged between 5.5% and 6%.

This is suggesting that the U.S. economy is deleveraging and recovering faster than the rest of the world, ostensibly less encumbered, at least for the moment, by the sovereign debt and banking crises.²

Over time, the performance gap diminishes, despite currency-related gains disappearing over time. Over the past five years, foreign outperformance is evident in four of the 10 sectors.

To help determine the most compelling U.S. sectors going forward, let's identify longer-term trends, reasoning that those U.S. sectors that stood up well over the past one, three and five years probably have something remarkable to offer investors.

Consumer Staples
The most consistent and least-volatile returns were generated by consumer staples. Up 13.61% over the past year, the sector's three- and five-year annualized gains through February 21 were 18.95% and 7.13%, respectively. Companies that manufacture and sell food, beverages and personal products, especially the large caps, have performed well across all markets.

According to Aiden O'Donnell, consumer analyst at Dublin, Ireland-based asset manager Davy, industry leaders such as Coca-Cola, Colgate and Procter & Gamble have keen advantages: branding and pricing power, emerging market access, and attractive dividends that are increasing on a regular basis.

Bob Lee, who manages Fidelity's Select Consumer Staples Portfolio with $1.2 billion in assets, says that these players also benefit from a wide competitive advantage they enjoy when it comes to access to large chain stores and shelf position.

But this sector possesses additional defensive qualities. Lee says that competition from cheap-labor countries has been a non-issue. Disruptive innovation, which challenges industry leadership across many sectors, is also a non-factor in retail. And he has found that even the Internet hasn't significantly altered the status quo.
Over the next six to 12 months, his major concern is that commodity prices will take off. "Last year," he notes, "we saw operating margins contract by 50 to 100 basis points as input prices rose." But Lee expects these costs to remain fairly stable in the near term and that increasing pricing power will push margins higher by up to 50 basis points. 3

Health Care
"The 85% of Americans having some form of health care insurance underpins the sector's inelastic demand," says Morningstar senior mutual fund analyst Christopher Davis. After posting trailing-12-month returns of nearly 12%, sector gains over the past three- and five-year periods were 14.36% and 3.17%, respectively. And despite the uncertainties surrounding ObamaCare, most industry observers think the sector will continue to deliver positive long-term performance.

Led by pharmaceuticals, health care services, medical devices and equipment, and biotech firms, the sector benefits from many of the same advantages enjoyed by consumer staples. Eddie Yoon, who manages Fidelity's Select Health Care Portfolio, with $2.2 billion in assets, explains key performance drivers include steady consumption driven by an aging population, high barriers to entry and increasing global sales-now including emerging markets-that's further entrenching sector leaders. And big pharmas, which make up nearly half the sector, pay dividends ranging from 3.5% to 4.5%.

Though the sector typically sells 10% to 25% above historical valuations, Yoon believes the continuing debate about health care has created unusual discount as investors remain cautious. With shares trading 5% to 15% below historical values, he sees opportunity.

"I believe if ObamaCare goes into effect," he says, "it will lead to more efficient health care, forging more innovative business models." He likens the law to disruptive legislation, with companies that fight the change likely to be left behind. Most vulnerable, he thinks, are companies with high-cost, less financially flexible business models.

Industry leaders made up Yoon's top three holdings as of the end of January: Amgen (bio-tech), Covidien (health-care products) and UnitedHealth Group (insurance). Ultimately, Yoon believes most doubts about the sector are already priced into the market and is optimistic about the next six to 12 months, expecting continuation of the status quo or something better.

Utilities
Electric, gas and water utilities, especially regulated companies, have always been viewed as solid defensive plays, more akin to bond proxies than equities. And the prolonged bond yield drought has helped these shares rally. One- and three-year returns are up 14.28% and 15.21%, respectively. While outperforming the broad market by 62 basis points, the sector's five-year annualized return is a less impressive 1.61%.

But to long-term money manager Mario Gabelli, there is long-term value in owning utilities. His Utilities Fund, with $2.7 billion in assets, has delivered annualized total returns of 7.77% over the past 10 years through March 1, outperforming the S&P 500 by 3.77% a year.

"Demand for these shares are being driven," Gabelli explains, "by the sector's relatively high yield that's twice that of 10-year Treasurys, dividend tax rates of just 15%, and industry consolidation."

Gabelli Utilities Fund manager Tim Winter adds that regulated electric utilities-to him the sector's sweet spot-are benefiting from rate increases supporting the current rise in capital spending. He says that "the demand for improved pollution controls, search for renewable energy and need for enhanced transmission from more diverse energy sources have been fueling rate increases that target returns on equity of 10% to 11%."

With dividend payouts of more than 60% of earnings, recoverable investment costs and inelastic demand, Tim O'Brien, who manages Wells Fargo Advantage Utility & Telecom Fund, with $375 million in assets, also believes that regulated electric utilities are especially attractive investments. But he sees risk. While dividend growth should continue, some valuations are getting pricy, Bush-era tax cuts may soon expire, and a rise in interest rates would hit shares.

Technology⁴
The time frame one is considering can significantly affect a sector's perceived long-term value. Technology shares offer no better example of this. It's returns were arguably the most impressive of all sectors, rising annually by a rate of 8.34%, 29.72% and 6.38% over the past one, three and five years, respectively.

There's no underplaying the fundamentals currently driving technology shares today. Apple is now the world's largest company. IBM has regained its former luster as the world's dominant IT services company. And with a dividend that tops those of 10-year Treasury yields, Microsoft is arguably a much better investment than the government.

With corporate America flush with cash, and now that state and federal governments have turned on the IT spending spigot, the Gartner Group found U.S. IT spending in 2011 rose 4.8%, breaking the trillion-dollar mark.

But the sector's outperformance reflects both its potential volatility and how far it fell during the financial crisis. Bottom-up value investor Greg Estes, who manages the Intrepid All-Cap Fund, which rose 23.6% annually over the past three years, saw tremendous value in tech shares in early 2009 after they were beaten down well below their fundamental value. Currently overweight in tech with more than 26% in the sector, Estes thinks the spending cycle will continue for the rest of the year. But he sees prices starting to reach fair valuations, with cash flow peaking. And that's the time he typically begins to start selling.

Philip Tasho, who manages the Aston-Tamro Diversified Equity Fund, whose three-year returns are up nearly 24.6%, explains that as a high-beta play, tech shares are more exposed to disruptive innovation than any other sector. "As seen with Nokia and RIM," Tasho says, "this phenomenon is capable of humbling any industry leader." Regardless of product or service, this makes technology shares more speculative than the other more defensive sectors described above.

1. This assessment was reconfirmed by a separate study of U.S. sector fund performance over the past year, prepared by Morningstar. It found the same three groups were among the top four-performing sectors.
2. Reflected in share performance, domestic businesses are spending and growing again.
3. James O'Shaughnessy, who manages his own firm with $4.4 billion in assets, studied the long-term market performance between 1968 and 2009. He found that consumer staples led the market, having delivered an average annualized return of 13.6%. And it did so with the second-lowest volatility. "Industries that make goods and services that people have to buy, regardless of economic circumstances," says O'Shaughnessy, "are bound to do well whatever the economic conditions."
4. Though there is no guarantee that investing in consumer staples, health care and utilities will bulletproof a portfolio, they have been relatively stable sectors that have generally outperformed the market with less volatility.