Want to outperform markets and generate alpha? Being invested in the right companies is only just a portion of the story – you have to be in the right sectors. Empirical data varies, but studies have shown that about 65% of stock market returns are correlated with the broader markets (e.g., if the S&P 500 goes up, most components are also likely to go up) and roughly 25% is due to sector (e.g., if financials rally than a banking firm is likely to do so as well). Only 10% of price movement is due to company-specific performance.Bottom-up investors – me included - face significant challenges in this regard. It can be easy to forget how important being invested in the right sectors is a major determinant in overall portfolio performance.
How should investors approach this? The risk-averse that do not believe they can time markets will likely take the safe approach: equal distribution across sectors or, if they benchmark against a major index like the S&P 500 (SPY), an allocation similar to that index. However, for those that want to generate alpha and beat indices there is going to be a need to do some market timing.
In most cases, sector-driven investors take a business cycle approach. Over time, sector performance is driven by cyclical factors that are quite often tied to the state of the economy: interest rates, inflation, profit margins. While every cycle can be different than those that came before it, major overarching themes tend to repeat. The below chart is a pretty good reflection of what sectors have outperformed/performed in prior cycles:
- Early cycle is going to be characterized by positive growth coming out of a slow/negative growth period. Monetary policy is likely to have been eased, labor is likely to be cheap and easy to find, and profit margins are likely to be expanding. This is a risk-on period with capital flowing into deep cyclicals (e.g., industrials) and credit exposed firms (e.g., consumer discretionary).
- Mid cycle is often the longest portion of the cycle. Growth is moderate, momentum is measured, and credit policy moves towards neutral. Given the Federal Reserve sees us as near rate neutral, the viewpoint of major policymakers is that this is where we stand today.
- Late cycle is like the flash of a candle; the calm before the storm. Growth begins to be impeded by higher inflation and overly restrictive monetary policy. Credit gets harder to find and margins come under pressure. Inventory builds are common. Investors flee into safety (e.g., utilities) or just leave equity markets entirely into cash or bonds.
Readers can see signs of this below from sector performance from 2000-2018:
*Comps: Materials Select SPDR ETF (XLB), Financials Select SPDR ETF (XLF), Industrial Select SPDR ETF (XLI), Technology Select SPDR ETF (XLK), Consumer Staples Select SPDR ETF (XLP), Utilities Select SPDR ETF (XLU), Energy Select SPDR ETF (XLE), Healthcare Select SPDR ETF (XLV), Consumer Discretionary Select SPDR ETF (XLY)
Of course, the market is always dynamic and is looking to predict the future. What is the market signaling today?
Early on in 2018, Technology and Consumer Discretionary companies were miles ahead of the other sectors on a relative basis. This was a clear indication that the market felt that growth would be set to continue for some time. However, by the end of the year Utilities and Healthcare ended the year well ahead. Capital flowed just where it would be expected to if the United States was truly about to see an economic slowdown.
If you’re a believer that the market is correct that a recession is right around the corner – this is the second longest economic expansion in history after all – then what did well in 2018 is likely to do well in 2019. Investing in utilities, particularly large cap utilities like Next Era Energy (NEE), Duke Energy (DUK), Dominion (D), and Southern Company (SO) makes perfect sense. Likewise, classic Consumer Staples safety picks like Procter and Gamble (PG), Coca-Cola (KO), Pepsi (PEP), and Kraft Heinz (KHC) all make for good plays.
But is that truly what is occurring? While economic data is clearly pointing to a miss on GDP growth in the United States in 2019 versus earlier expectations and overseas figures are far worse (Europe bordering on zero growth, China slowing) there is an argument that the recent price action is overdone. Could Industrials and Technology, both sectors that turned in great performance in 2017 before slipping in 2018, be oversold? The major Industrials (Honeywell (HON), United Technologies (UTX), Caterpillar (CAT)) could be counter-culture plays as well as capital rotation into the large cap Technology picks (Microsoft (MSFT), Alphabet (GOOG), Apple (AAPL), Facebook (FB), Intel (INTC)).
Takeaway
This is a tough call to make. I flipped bearish on late cycle firms in the middle of 2018 based on what I felt were overexuberant GDP growth expectations and my view the Federal Reserve would have to back off its rate hike schedule. However, I’ve even been taken aback by the stark risk-off mentality in small cap plays that carry risk into a late cycle. I was never looking for a recession – just slowing growth. Personally, I remain overweight Industrials and Technology small caps based on my view that the recent sell-off has been overdone. Nonetheless, I'm deeply respectful of sentiment.
To me, this seems like a game of musical chairs. Everyone knows the music is going to stop at some point. However, many in the market are jumping the gun, trying to sit down while the song is barely half over. There will be a time to rotate to safety in my view – now is not quite the time.
