Sector rotation is the rise of stocks in one industry, or sector, at the expense of stocks in other industries. For instance, investors fearing the broad market is poised for a correction may shed their riskier technology names and replace them with safer, more reliable utilities stocks. The selling causes technology names to lose value, while the buying pushes utilities stocks higher.
This stock-swapping process is rarely clear. Investors also don’t always replace tech names with utilities stocks. Sometimes they may choose to replace their more aggressive technology stocks with similarly risky energy names. It’s also not unusual for all stocks to be rising or falling in tandem, even if they’re doing so at different paces. The point is, nobody ever really knows how investors’ perceptions of different industries are shifting.
And there’s the rub. We know sector rotation is going to happen. We just don’t know how or when it’s going to take shape. The good news is, we can — and should — plan for this unknown.
A close look at some stock market charts just might bolster your bottom line in a big way by changing how you manage your portfolio… by making you less aggressive.
A huge gap between the best and worst
The circumstances of 2020’s COVID-19 pandemic were so unusual that nobody should be using last year as an example of how the market operates. The last time things were “normal” was 2019. So, that’s the year we’re going to use as the basis for our focus chart… and our bigger point. Using some of the more popular exchange-traded funds (ETFs) as proxies for the broad sector groups, we can see 2019’s overall gain of nearly 29% for the S&P 500 wasn’t even close to the same sort of gain some sectors made in the very same year. At the winning end of the scale you’ll find the Technology Select Sector SPDR (NYSEMKT:XLK) with a gain of almost 48%, while the Energy Select Sector SPDR (NYSEMKT:XLE) logged a gain of less than 5%.
From best to worst, that’s a performance difference of 43 percentage points, which is far more than the overall market gains in the average year! Just for some extra perspective we’ve also included the second-best and next-to-worst sector ETF performances in our look at 2019’s sector-based returns above. The gap between them is still pretty wide too, at 18 percentage points.
Surprised? A lot of people are.
Most investors understand some groups do better than others in any given year. What they may not realize, though, is how much better some sectors do compared to others. The 43 percentage points that separated tech stocks from energy stocks in 2019 is actually close to the usual spread between any year’s best and worst sectors. Investors that were overexposed to the technology sector in 2019 are thrilled with the decision, but folks holding out for a big rebound in energy stocks that year have to be disappointed they didn’t even match the overall market’s return.
Here’s the thing. As of early 2019, how many of us really knew technology stocks or the names that make up the the Financial Select Sector SPDR ETF (NYSEMKT:XLF) would do so well over the course of the coming twelve months? Or, how many of us knew the energy sector or the stocks that make up the SPDR S&P Telecom (NYSEMKT:XTL) would perform so badly? If we’re being honest, not many. And the people who did see what was coming were at least as lucky as they were smart.
This is why investors should diversify their portfolios across several sectors, if not all of them. The downside of holding too many stocks in the wrong sectors is much bigger than the upside of concentrating in the market’s winning sectors. Not only has your portfolio underperformed, you’ve now got one less year to make up that ground.
Leadership never lasts
And yet, there’s more to the story than the point made by a deeper look at 2019’s sector performance chart. You only have to go back and look at previous years’ sector performances to appreciate that sector leadership (and laggardship) is not only always changing, but also rather unpredictable.
Here’s 2018’s comparison. Technology stocks didn’t lead. Neither did financials. In fact, the only sector ETF to log a meaningful gain in 2018 was the Health Care Select Sector SPDR Fund (NYSEMKT:XLV). Energy stocks were once again at the bottom of the pile with nearly a 21% loss, but this time they were closely followed by the 16% setback suffered by the Materials Select Sector SPDR (NYSEMKT:XLB)…
… the very same materials ETF that did so well the year before. Yes, in 2017, technology stocks were back on top with a 32% gain, but the runner-up was the Materials Select Sector SPDR with nearly a 22% gain. And, similar to 2019, the difference between 2017’s best and worst-performing sector was an incredible 36 percentage points.
Here’s one more reference chart to consider: 2016’s sector comparison. That year, energy stocks (the same sector that would lag the next three years) led the market with a 25% gain. Also in 2016, telecom stocks (yes, another big laggard for the next three years) closely followed energy names with their 23% advance. The same technology stocks that have led the way most of the time since then were just mediocre performers in 2016, while the healthcare sector was the proverbial problem child with a 4% loss in 2016. From best to worst, 2016’s sector performances spanned 29 percentage points, rewarding oversized bets on energy but punishing big bets on healthcare and consumer staples.
The point is, no sector leads or lags for very long, and the performance differences resulting from these leadership changes can easily exceed 30 percentage points in just one year.
The way to win
If you have the inclination, information, and experience to do so, then sure, overexposing yourself to the right sectors and steering clear of the wrong ones could theoretically lead to market-beating gains. You don’t even have to successfully identify all the budding sector trends. Just spotting most of them is a way of improving your bottom line, as the gap between any given year’s best and worst-performing industries is surprisingly big.
The fact is, however, no one — not even market professionals — has a proverbial crystal ball when it comes to spotting sector rotation. Indeed, sometimes we seem particularly bad at spotting it. That’s a problem simply because the cost of getting it wrong can be even greater than the upside of getting it right.
Remember, lagging the broad market for any length of time means you’re behind on your goals, and the one thing you can never get back is time. That’s why we’re all truly better off just remaining well diversified all the time.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.