Using Sector SPDRs to Play the Market the Right Way

Sector SPDRs

Sector SPDRs group the market in 10 categories, where we can select the ones we want and the ones we don’t. Going with the better half of these makes a lot of sense.

We can categorize stocks into two categories, the ones that outperform and the ones that underperform. If we buy a stock market index, we get our basket filled with all of them, the good, the bad, and the ugly.

We should, of course, prefer the good and don’t really want the bad and especially not the ugly. We also don’t want to have to bother picking individual stocks, which in the right hands can help us, but as investors, we are way out of our league here and most of the pros are out of their league as well as it turns out because they don’t focus on what is important and have their own ideas about what makes a good stock.

If the market has different ideas, and with many of these stock pickers they do, then we’re just going to be wrong. Rather than try to fight the market, it’s better to just look to ride along with what it thinks are the good and bad ones, and this also applies to sectors.

While past performance doesn’t guarantee future performance, and there are no guarantees with investing, they sure do point to it in terms of probability, and probability is all we have here. Sectors that are liked have a higher probability to continue to be liked on a year to year basis. We don’t want to just look at what has been hot last year to decide what will be a good choice for next year though, as while we expect another good year next year, it won’t be as good as last and will probably come in between the dreary year that 2018 was and the excitement of 2019.

We can therefore look at how each sector has done over the last 2 years rather than the last one, and this will give us a better picture of what to expect then just looking at which ones have put up the better numbers last year. The goal here is to pick the upper half of these, the better 5, and ditch the lower 5, as if we’re out to beat the market, we won’t do it by holding the garbage half of it. The best way to do this and be very well diversified at the same time is to take the good and toss out the bad.

We don’t just want to look at returns though, as we need to account for other factors as well, and we therefore prefer the seventh-place financial sector over the fifth-place biotech sector in spite of the 3% better performance of biotechs over our two-year period. Biotechs are just too risky, even in a bull market, and they are simply too all over the place to want to be adding them over better performing sectors that aren’t even as risky, and this even includes technology. Technology is riskier in a bear market of course, but the nature of the business with biotechs is where most of their risk comes from, and this is the real boom and bust sector.

Financials, on the other hand, did quite well in 2019, due to the more dovish stance of the Fed, and suffered a lot more than average from the more hawkish 2018. We’re still very much in dovish territory and this does bode well for financials having another good year, where with biotechs, this is left more to chance than we would like.

Biotechs returned 13% over the last 2 years, with financials only delivering 10%, but we like the financial sector more in 2020 so we’re going to override these numbers and go with the safer bet here which may also outperform next year but avoids all that volatility.

Since the idea of this strategy is to shoot for the better half of the market, driving returns but not taking on too much risk, going with financials make sense as long as the Fed remains on their side. Many people think low rates are bad for financials and high rates are good for them, but when we test this theory in the real world, it ends up being dead wrong, and we want to be right.

The 27% return that the financial sector gained in 2019 does speak well for this effect, and all signs point to this continuing and our having another good year in 2020 with this sector. Financials well deserve to be in our top half and even if they don’t crack the top 5 next year, they will be solid enough to want us to have them in our basket.

The Best Sectors Have Clearly Outperformed the Lesser Ones

This is about what we don’t hold as much or even more than what we do hold, and as it turns out, the stuff we don’t want is pretty easy to spot. Aside from biotechs, we certainly want to steer well clear of the energy sector, which can only be described as toxic right now, and will more likely than not remain that way for some time, perhaps forever in its current form.

The energy sector was the only sector to lose over the last 2 years, and actually went down by an alarming 18%. The S&P 500 has moved away from this sector more each year, and we want to be completely rid of it without question. We can help ourselves a lot just with this move.

The next worst performing sector, in ninth place, is the materials sector, which has delivered exactly nothing over the last 2 years. It’s good not to lose, but we want to not only be making money with our investments but good money, and this is a dead sector right now and will just bring down our returns by diluting them with junk.

The industrial sector sits in eighth place with a combined return of 8%, which is only 2% less than the financials, but there just isn’t enough growth happening in this sector compared to the potential with financials right now. The same is true with consumer staples at 11%. With the reference return of the total S&P 500 coming in at 18%, if we’re going to be picking below this, we’re going to need a good reason to do so, and there simply aren’t good reasons to pick either of these sectors.

The top 4 sectors have all beaten the market average by a good margin and are poised to continue this. In fourth place sits the utilities sector, which many think is something old people or those who are too much on the conservative side like, and this sector manages risk like no other, and nothing even comes close. Utilities laugh at big pullbacks when everyone else is running for the exits, but they also have been providing a lot better returns than we may think.

In terms of risk/return ratios, utilities are a very nice combination, with a maximum drawdown over the last 2 years of only 7%, and an overall return of 22% versus 18% for the market overall. This definitely needs to be in our basket for both reasons and we wouldn’t be that far off from the average return of our top 5 sectors of 25% if we just put all our eggs in this one and would be managing risk much better.

Utilities are always less risky than the market in general and especially handle bear markets much better, as they are as far from a cyclical business as you can get. These stocks normally require us to give up a fair bit of return to have this benefit though, but as we can see, this hasn’t been the case over the last couple of years. As the bull market goes on for longer and longer, more money is being put into them for hedging purposes, and this should continue into next year at least.

Investors who find going with the upper half of the market too rich for their blood, perhaps due to a shorter timeframe and needing to manage risk more closely, or just with those who are more risk averse, they may find a home they really like in this sector. This especially makes a lot more sense than investing in bonds, especially now with bonds so risky.

The health care sector has taken a hit from all the worry about political change hurting a lot of these companies, but through all this, they still have managed a 25% gain over the last 2 years, earning them third place overall. This really is a sector that is primed to keep growing well and Medicare for All, like the wealth tax and other hardcore socialist proposals, is just a pipe dream that should not have us hesitate to jump on this bandwagon.

It is not that there isn’t any realistic potential issues that will affect the health care sector, but their impact will be minor enough to be engulfed by the forward progress this industry is making, and when you have a sector where people complain a lot about excessive growth, this is something we want our money bet on.

The consumer discretionary sector comes in at number 2 on the list with a 27% increase over the last 2 years, and given that we’re out for a sensible amount of diversity with our top half of the market approach, this one also fits the bill. This also wins for the most consistent sector on the list, where it has virtually gone straight up over the last 10 years and its 772% growth since March 2009 beats everyone including the technology sector.

Over the last 2 years though, the technology sector clearly beats all other sectors and finishes in first place with a gain of 43%. While all of this was from 2019, it at least stayed even in 2018, which was not a good year for any sector really, and even utilities finished the year flat.

Overall, our top 5 averaged a return of 25% versus the only 7% that our bottom 5 sectors gained. This includes our giving up a few percent to take the financial sector over the biotech sector, and while there are people that are very bullish on biotechs next year, and they could have a very good year, but this sector isn’t as good as many think, perhaps from seeing the bursts that it is capable of and assuming this translates well over time.

This Works Looking Longer Out as Well

Taking a look at 5 years out will serve to allay any concerns that our using the last 2 years might not be a long enough sample, and we really wouldn’t want to look beyond 5 because the data starts getting too distanced and old from there.

The top 4 performing sectors over the last 5 years are all ours. Technology leads the way with 118%, followed by consumer discretionary’s 75% and health care’s 49% the top 1, 2, and 3 from the 2-year study.

Financials get fourth place with their 52% gain, and this particularly supports our call to elevate it over biotechs. It both has the recent performance over 2019 and the longer-term performance over the last 5 years to have it deserve to be in our top half.

The industrial sector actually came in fifth, but not in a way we could ever like, because it hasn’t been performing well for quite a while. The fact that this is only a hair over its January 2018 levels and has put in all of this 42% gain in the period between January 2016 and January 2018 serves to make this number much smaller and too small to get them into our top 5.

Utilities came in sixth with 33%, so we see that all 5 of our sectors fall in the top 6, and only are intruded by the industrial sector which has become too rusty to be worthy of consideration regardless. Biotech shows its lack by coming in seventh with 41%, with consumer staples at 28% and materials with 25% rounding out the top 9. Energy of course comes in dead last again, and using dead here is pretty appropriate given their loss of 23% in the last 5 years.

This has our picks averaging 65% versus the 21% that the ones we are tossing managed on average.

Momentum is a real phenomenon with stocks and indexes, and the reversion of the mean is long dead. By confirming the momentum that we are looking to invest on not only in the present, but 2 and 5 years back as well, really adds to the probability of this selection not only beating the market but well beating the discarded sectors. That’s all you have to do in fact.

Selecting stocks while seeking a diversified basket always involves the process of exclusion, as we don’t want to just own them all or we would just buy the broad index and we need to be able to look at a stock or an index and be able to decide that it is not for us. By sorting out the SPDR sector ETFs, like they show in their commercial, by looking to get rid of the underperforming sectors, is exactly what we want to be looking to do.

Beating the market is more a matter of casting off our slow runners than it is looking at fast ones when it comes to raising our average speed. Just tossing the energy sector itself would do a world of good as this is grappling the index and wanting to take it down, and has done so pretty successfully.

It also makes sense to retain above-average sectors if we expect above-average returns. Below average performers put these down every time.

No one can ever predict which sectors will outperform and underperform with any great accuracy, because there are too many unknowns. However, you will travel further if you are swimming with the tide instead of against it, even though it may shift from time to time, and the only way to do this is to check which direction it is going.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.