Sector Investing

Rick Welch |

A sector is an industry classification or grouping of companies sharing common characteristics.  The most common structure of industry sectors, the Global Industry Classification Standard or GICS, divides the equity universe into eleven major sectors: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate and Utilities. Since the development of GICS in 1999, there has been just one major sector change that being in the fall of 2018 with the expansion of the old Telecommunications Services sector to include companies from the Consumer Discretionary (Charter Communications, Comcast, Netflix, Time Warner and Disney) and Technology (Alphabet and Facebook) sectors.  The new sector (which also includes AT&T and Verizon) now goes by the name Communication Services and represents almost 11% of the S&P 500. The impact of this change was the largest in the history of GICS as it required the reclassification of more than 10% of the S&P 500 Index (by market cap) and involved 26 S&P 500 stocks.

There are many ways to construct an equity or stock portfolio, including the more traditional approaches of market cap (large, mid or small), geography (US or international) and style (growth or value). The view of the suitability of these three approaches may now be changing as recent long-term studies of stock return differentials suggest that industry sectors may be a more important component of equity returns than market cap, geography and style combined.  A focus on industry sectors can provide the investor with a clearer understanding of where stock price returns are generated. Sectors provide many benefits, including their typically static composition, clear patterns of volatility and low correlation to each other.   While a company’s market cap or style grouping can change, its’ sector classification typically stays the same, the 2018 reconfiguration of the Communication Services sector being the exception. As the economy moves through a business cycle, sectors will often perform differently causing them to move out of sync with each other.  For example, the Technology and Consumer Staples sector have a low correlation (0.32), which means that their stock prices will move in the same direction (up or down), but, at much different speeds. The construction of a portfolio with assets that have low correlation can potentially improve overall diversification.

This makes sense to us. We think that the implementation of a sector rotation strategy within an equity allocation can bring precision to your portfolio. A sector rotation strategy provides an efficient means to adjust equity weightings within a portfolio based on an understanding of where we are in the current business cycle. A typical business cycle has four distinct stages: Early (a rebounding economy with strong earnings growth), Mid (credit expands, earnings are strong and economic growth peaks), Late (economic growth moderates, credit tightens and earnings decline) and Recession.  History teaches us that sector performance can vary significantly depending on the stage of the business cycle. Early stage above trend performance is often seen in Consumer Discretionary, Financials, Industrials and Technology. By the time we move through the Mid into the Late stage, we see that strong sector performance is expected more from Consumer Staples, Energy, Health Care and Materials. In Recession, we might expect above market returns from Consumer Staples, Health Care and Utilities. Where are we now in the current business cycle? Probably in the Mid cycle phase of expansion, with levels of economic activity tied to ongoing broad scale vaccination programs and reopening progress.