By Wallace Witkowski, MarketWatch

SAN FRANCISCO (MarketWatch) -- An improving economy is set to mix up sector winners and losers in the second half of the year, particularly if Treasury yields recover and long-awaited capital improvement spending kicks in.

At end of the last full week of trading in the first-half of 2014, the S&P 500 Index (SPX) is up 6.1% for the year, with the Dow Jones Industrial Average (DJI) up 1.7%, and the Nasdaq Composite Index (RIXF) up 5.3%.

Airline, pharmaceutical, and utilities stocks were the big winners in the first half of 2014; a period marred by bad weather, a drop in first-quarter GDP, and a drop in Treasury yields.

Of those three, pharma stocks are expected to hold firm given a recent wave of mergers and acquisition activity, said Brian Belski, chief investment strategist at BMO Capital Markets. Airlines and utilities face a more uncertain future.

Utilities and real-estate investment trusts are getting action because they are bond proxies for the most part, Belski said. Investors, surprised that the yield on the 10-year Treasury (10_YEAR) dropped below 3%, rushed toward these sectors in search of yield, he said.

"We're underweight on utilities because they're the most expensive," Belski said. "If and when the economy improves they're going to be at risk."

All it will take is a steady upward trend in 10-year Treasury yields to start loosening money out of those defensive plays, said John Canally, investment strategist and economist at LPL Financial. Momentum in utilities, in particular, picked up as 10-year yields dropped from 3% in January. A return to 3% will turn the bulk of that money back into cyclical stocks, he said.

Do consumer stocks turnaround?

As a whole, the consumer discretionary sector is the worst performing of the 10 broad S&P 500 sectors for the year. It has seen some marginal improvement recently, rising about 1% on the week following improvements in consumer sentiment and consumer spending.

Canally believes some of the burden on brick and mortar retailers may be from higher energy prices, with more consumers content to do their ordering online. Right now, he sees a disconnect between consumer stocks and consumers. First-quarter GDP numbers would have us believe the consumer is horrendously overburdened, but mostly the opposite is true with consumer debt burdens lower and improved employment prospects, he said.

Even so, it's still unclear whether retail stocks will recover much. LPL Financial pointed out in a recent note that retail sales jumped in late April and early May, citing International Council of Shopping Centers figures. But Belski said that retailers still have structural issues they need to overcome.

Stocks that have hung like a millstone around the neck of the retail sector this year include Staples Inc.(SPLS) , Bed Bath & Beyond Inc.(BBBY) , Best Buy Co.(BBY) , all with share-price losses of more than 20% on the year. In the multiline retail space, shares of Target Corp. (TGT) have been particularly weak with an 8% decline on the year.

Airlines flying high?

Airlines, part of the industrials sector, have had a particularly high-flying year as the best performing subsector on the S&P 500. While that 43% rally includes just S&P 500 components Delta Air Lines Inc. (DAL) and Southwest Airlines Co.(LUV) , other non-S&P 500 airlines have rallied as well. Shares of American Airlines Group Inc. (AAL) are up 75% for the year. Shares of JetBlue Airways Corp. (JBLU) have gained 26%. And United Continental Hioldings Inc. (UAL) is up 9%.

That's not sustainable according to Belski. Much of the run-up in airlines has come from reduced capacity, more efficient cost structures, and more revenue from fees on bags and cabin services. As the economy improves, he argues, airlines are going to be forced to increase capacity, putting pressure on seat prices, and in turn, stock prices.

Higher energy prices could also derail the rally in airline stocks, Canally said. But, at the same time, airline activity could also hint at more capital spending in the works implied by increased business travel to make deals. Also, higher prices and fees haven't deterred non-business travelers.

Capex key

Capital expenditure spending is still a key to jump starting industrials and adding to tech company gains, Belski said. Many investors still don't believe that a return to large capital expenditure is likely, and that's holding industrials back.

That's been a strike against the largest component of the industrial conglomerates subsector, General Electric Co. (GE), with shares down 5.7% for the year.

With respect to industrials, many investors have been focused on the sector's exposure to emerging markets and not on North American economic expansion, Belski said. When you look at earnings, however, it's those companies with more north American exposure that have better earnings outlooks and more attractive valuations, he said.

Canally also noted that durable goods spending will likely improve from the first half, and have already started turning around as core capital goods shipments expanded, while commercial and industrial loans have picked up recently.

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