1. I N V E S T M E N T S T R A T E G Y G R O U P
The Importance and Opportunities
of Sector Investing
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The Economic Sectors of the Stock Market
The S&P 500 stock index is made up of 10 sectors
and 70 industries within these sectors. The fol-lowing
10 broad sectors segment the significantly
diverse companies of the S&P 500: Consumer Dis-cretionary,
Consumer Staples, Energy, Financials,
Health Care, Industrials, Information Technol-ogy,
Materials, Telecommunication Services, and
Utilities. Sector classifications benefit from being
intuitive and stable. Companies are classified based
upon the nature of their major business line and
tend to remain in their sector.
This segmentation tends to put companies with
similar operating characteristics and industry fun-damentals
into the same sector. The economic cycle
and interest rate environment also tend to impact
companies of a given sector in a similar manner
(more on this below). These factors cause the per-formance
of sectors to vary significantly—relative to
the market as a whole, and to other sectors. It is this
variability of returns between different parts of the
market that presents the opportunity for investors
to enhance portfolio returns.
The Importance and Opportunities of Sector Investing
While most market observers focus on the direction of the stock market as a whole, there are very
important dynamics occurring under the surface of the market that offer significant investment
opportunities. Sector exposure has been a major determinant of stock market returns and is
widely considered the second-largest return factor after individual security selection.
Performance History of Stock Market Sectors
Table 1 shows the range of returns for the best sec-tor
and worst sector for the last decade. While the
S&P 500 had an average return of 9.2%, the best-performing
sector had an average return of 29.8%,
while the worst had an average of –5.6%—indi-cating
that proper sector exposure is critical for
portfolio performance. The table also shows that
proper sector exposure is much more important
than the decision on capitalization (large vs. small)
or style (growth vs. value). While the average dif-ference
between best vs. worst sector performance
is 35.3%, it is only 4.6% for large vs. small capital-ization,
and 6.3% for growth vs. value. The sector
decision is also more important than the decision
on international exposure, with the average differ-ence
between U.S. and developed international
performance only 7.8%. A savvy investor pays at-tention
to his sector exposure at all times.
The rank order of sector performance also fluc-tuates
significantly from one period to the next.
Appendix 1 shows the significant yearly variation in
sector performance.
Table 1: Range of Returns by Sector, Capitalization, Style, and Region
Average 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004
S&P 500 9.2 32.4 16.0 2.1 15.1 26.5 –37.0 5.5 15.8 4.9 10.9
Best Sector 29.8 43.1 28.8 19.9 27.7 61.7 –17.7 34.4 36.8 31.4 31.5
Worst Sector –5.6 11.5 1.3 –17.1 2.9 8.9 –55.3 –18.6 7.5 1.0 1.7
Average Difference 35.4 31.6 27.5 37.0 24.8 52.8 37.7 53.0 29.3 30.4 29.9
Large Cap Stocks 9.7 33.1 16.4 1.5 16.1 28.4 –37.6 5.8 15.5 6.3 11.4
Small Cap Stocks 11.1 38.8 16.3 –4.2 26.9 27.2 –33.8 –1.6 18.4 4.6 18.3
Average Difference 4.6 5.7 0.1 5.7 10.8 1.3 3.8 7.3 2.9 1.7 6.9
Large Growth 9.9 33.5 15.3 2.6 16.7 37.2 –38.4 11.8 9.1 5.3 6.3
Large Value 9.4 32.5 17.5 0.4 15.5 19.7 –36.8 –0.2 22.2 7.1 16.5
Average Difference 6.3 1.0 2.3 2.3 1.2 17.5 1.6 12.0 13.2 1.8 10.2
Developed International 9.5 22.8 17.3 –12.1 7.8 31.8 –43.4 11.2 26.3 13.5 20.2
Average Difference from S&P 500 7.8 9.6 1.3 14.3 7.3 5.3 6.4 5.7 10.5 8.6 9.4
(Source: Janney ISG, Bloomberg)
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Sector Allocations Drive Portfolio Returns
Numerous academic studies have examined the
impact of sector performance variability. Not sur-prisingly,
these studies confirm that sector selection
is the critical determinant of portfolio performance.
Stocks and Industries are
Highly Correlated with Sectors
Table 2 shows that most stocks and industries are
highly correlated with their sector. The average
industry has a very high correlation of 0.80 with its
sector (correlation measures the strength of a rela-tionship—
with 1.0 implying a perfect relationship,
0.0 implying no relationship, and –1.0 implying
a perfect inverse relationship). In addition, the
underlying stocks are usually highly correlated with
their sector as shown in Table 2. This implies that
owning stocks in the right industry and sector is
critically important for portfolio performance.
The high correlations of the Energy, Financial,
Industrials, Materials, and Utilities sectors with
their underlying stocks indicate that the stocks
in these sectors are driven by macroeconomic
factors or strong industry dynamics, more so than
firm-specific issues. For these sectors, exposure
to the sector is more important than exposure to
the individual stocks within the sector. Exchange-traded
Funds (ETFs) offer an excellent way to
participate in sector or industry themes without
taking on firm-specific risk and are very appropri-ate
for these sectors.
By contrast, the relatively low sector/stock correla-tions
of the Consumer Discretionary, Health Care,
and Information Technology sectors imply that
more can be gained by exposure to firm-specific
issues rather than industry/macro issues. New
drugs, and hot consumer and technology products
are examples of firm-specific issues that can enable
individual stock outperformance.
Analytical Approach to Sector Analysis
The 10 S&P sectors can be classified as defensive or
cyclical. Defensive sectors have stable earnings that
are not a strong function of the economic cycle.
They provide goods and services that people need,
independent of economic conditions. They tend
to outperform when the economy is performing
poorly. Defensive sectors include Consumer Staples,
Health Care, Telecommunications, and Utilities.
Cyclical sector profitability is a strong function
of economic conditions. When economic condi-tions
are good, these sectors see strong profits
and, consequently, they tend to outperform the
overall market. Cyclical sectors include Consumer
Discretionary, Energy, Financials, Industrials, Infor-mation
Technology, and Materials.
The economic cycle and corresponding Federal Re-serve
(Fed) interest rate policy are major top-down
determinants of sector performance. We break
the economic/interest rate cycle into phases—de-termined
by whether interest rates are restrictive
(tight) or accommodative (easy) for economic activ-ity
and whether rates are moving higher or lower.
Table 3 shows relative performance for the sectors
during interest rate cycles since July 1970.
Table 2: S&P 500 Sector, Industry, and Stock Correlations
S&P 500 Sector Stock Correlation with its Sector Average Correlation of Industry
Returns with Sector Returns Sector Correlation with S&P 500
Consumer Discretionary 0.68 0.80 0.89
Consumer Staples 0.76 0.80 0.71
Energy 0.79 0.79 0.71
Financial 0.78 0.80 0.83
Health Care 0.60 0.78 0.72
Industrials 0.81 0.87 0.93
Information Technology 0.66 0.72 0.85
Materials 0.83 0.87 0.74
Telecommunications 0.90 (T & VZ) 0.75 0.81
Utilities 0.85 0.84 0.51
Source: Janney ISG, Bloomberg, and BCA Research
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An accommodative credit environment is con-ducive
for economic activity and is favorable for
stocks, particularly cyclical sectors. Table 3 shows
the cyclical sector outperformance during the ac-commodative
phases.
Table 3 also shows that an accommodative
environment is unfavorable for defensive sec-tor
outperformance. Defensive sectors tend to
perform well during a restrictive credit phase.
Restrictive credit conditions are a major cause of
recessionary economic conditions where defensive
sector profitability holds up better—and hence the
stocks outperform.
The U.S. economy has been in an accommodative
interest rate environment since the financial crisis,
and the economy has been in recovery since the
summer of 2009. The ultra-accommodative interest
rates are now ending, and the Fed is contemplating
raising rates. We anticipate rates will be accom-modative
well into 2016. This rate environment
remains favorable for economic activity and cyclical
sectors. It should also be quite some time before
restrictive credit conditions cause an unfavorable
environment for stocks and allow for sustainable
outperformance from the defensive sectors.
Table 3: S&P 500 Sector Returns Relative to Overall Index Returns during Rate Cycles from 1970
Accommodative and
lowering rates
Accommodative but
rising rates Restrictive and rising rates Restrictive but
lowering rates
CYCLICALS
Consumer Discretionary 7.6% –8.1% –5.4% 0.1%
Energy 4.5% 12.0% 1.1% 5.1%
Industrials 2.4% 8.4% –1.7% –4.1%
Materials –0.1% 8.9% –1.3% –3.0%
Technology 2.6% 15.0% 4.6% –4.2%
DEFENSIVES
Consumer Staples –3.8% –2.7% 4.9% 14.3%
Health Care –3.4% 1.9% 10.2% 5.2%
Telecom –4.2% –9.2% 4.1% 8.2%
Utilities –9.1% –14.4% 1.3% 8.7%
Source: Janney ISG, BCA Research
Sector Fundamentals
Also Determine Performance
A thorough analysis of sector fundamentals is
also important for determining the potential for
outperformance. This includes valuation analysis
that looks at whether a sector is expensive or cheap
relative to its own history, and relative to other
sectors. The potential for revenue and earnings
growth and competitive dynamics of the sector are
important considerations. In addition, sectors see
secular trends that provide headwinds or tailwinds
for performance that need to be thoroughly
analyzed. The following section looks at favorably
positioned sectors.
5. WWW. J A N N E Y. C OM 5
Technology:
There are strong secular drivers for tech spending.
Tech investment has fallen to close to a 15-year low
as a share of overall investment, underscoring that
the average age of its capital stock is particularly
high. The corporate sector also needs to address
weak productivity growth (an indication that pro-longed
underinvestment may have begun to take a
toll on corporate efficiency).
Meanwhile, corporations are in a solid position to
invest—with profits at new highs, while the barriers
for investment are falling as the economy contin-ues
to improve. Recent manufacturing data show
that technology new orders are firming, suggesting
that capital spending budgets are being directed
toward technology goods. Despite the positive
cyclical and secular backdrop, tech valuations
remain reasonable.
Health Care:
Health care also has a positive secular backdrop
due to aging demographics and the associated in-creasing
demand for health care services. Overall
health care demand is recovering, as the U.S. econ-omy
improves and unemployment levels continue
to decline. The pace of health care expenditure
growth should exceed that of the overall econo-my—
with pent-up demand for health care services,
lower unemployment levels, and rising commercial
insurance membership bolstering the sector.
While the pace of growth may be slowed by new
reforms, that should be outweighed by the positive
impact on valuations from a lifting of health care
reform uncertainty. Growing affluence in emerg-ing
markets is also providing opportunities for
equipment and pharmaceutical companies.
Financials:
As private sector balance sheets and credit quality
have improved, bank lending standards have been
relaxed. Both consumers and businesses are ben-efitting
from this easier access to funding, and loan
demand has been slowly improving with employ-ment
growth. Indicators also show small-business
lending returning to levels seen prior to the finan-cial
crisis. Meanwhile, there remains significant
pent-up demand for housing, autos, and corporate
capital expenditures—implying strong pent-up
demand for consumer and business loans.
More readily available credit (and demand for it)
has typically been a leading indicator of financial
sector profit acceleration. This cycle, the sector has
the added benefit of rising productivity growth,
measured as total credit growth per employee. Pro-ductivity
is now growing at its fastest pace since the
global financial crisis. In addition, loan charge-offs
have declined to pre-crisis levels, and non-current
loans have also dropped below 2008 levels.
While deflationary pressures from abroad are
keeping financial sector valuations depressed, this
should be viewed as a buying opportunity given
the positive profit outlook. This sector is also a
strong dollar winner (keeps inflation low and sup-ports
domestic purchasing power—both positive
for loan growth), which should provide a further
incentive for a valuation re-rating.
Table 4 (on page 6) summarizes the stocks and ETFs
that are benefiting from these positive sector themes.
Michael J. Halloran, CFA, Strategy Analyst
Mark Luschini, Chief Investment Strategist
Sectors that are Currently Well-Positioned
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Table 4: Stocks and ETFs of Well-Positioned Sectors
Company Name Ticker Forward
P/E
Earnings
Growth
Dividend
Yield
Credit
Rating Notes Coverage
Technology
Tech investment has fallen to a 15-year low as a share of overall investment. This indicates significant pent-up demand for technology products
that will be needed to address weak productivity growth. Corporate confidence is improving, and companies are well-positioned to execute on
their capital expenditure plans.
APPLE INC. AAPL 14.46 15.97 1.63 AA+
Providing leading edge wireless
productivity solutions for
consumers and business.
S&P/CS/J
MICROSOFT CORP MSFT 16.95 9.22 2.35 AAA New product releases are just in
time to help increase productivity. S&P/CS
ORACLE CORP ORCL 13.04 9.67 1.19 A+
Enterprise technology solutions are
at center of corporate productivity
enhancements.
S&P/CS
QUALCOMM INC. QCOM 13.52 13.37 2.19 NR Leading provider of wireless
broadband technology. S&P/CS
EMC CORP/MA EMC 14.02 11.07 1.50 A Storage is always at the top of the
IT budget list. S&P/CS/J
VANGUARD INFO TECH ETF VGT – – – – Cap-weighted basket of 410 info
tech stocks.
ISHARES SOFTWARE ETF IGV – – – – Cap-weighted basket of 55 U.S.-
traded software companies.
ISHARES COMMUNICATION ETF IGN – – – –
Cap-weighted basket of 32 U.S.-
traded multimedia networking
companies.
Financials
The Financial sector has healed from the financial crisis, and is well-positioned to extend the needed credit for pent-up business and consumer
expenditures as the economy improves.
PNC FINANCIAL SERVICES GROUP PNC 12.37 5.21 2.09 A- Major regional bank with focus on
Pennsylvania and Ohio. S&P/CS
AMERICAN EXPRESS CO. AXP 15.60 9.42 1.07 BBB+ Leading global payments and travel
and expense services company. S&P/CS/J
ALLSTATE CORP ALL 11.99 8.78 1.62 A- Second largest U.S. personal lines
property-casualty insurer. S&P/CS/J
PRUDENTIAL FINANCIAL INC. PRU 8.61 10.67 2.49 A
Provides a wide range of insurance
and investment management
products.
S&P/CS/J
GOLDMAN SACHS GROUP INC. GS 11.21 10.17 1.16 A-Leading
position in investment
banking, securities, and wealth
management.
S&P/CS
FINANCIAL SELECT SECTOR SPDR XLF – – – – Includes 80 stocks for broad-based
financial sector exposure.
SPDR S&P REGIONAL BANKING KRE – – – – Includes 79 equally weighted
regional bank stocks.
ISHARES U.S. INSURANCE ETF IAK – – – – Includes 64 U.S. insurance provider
stocks.
ISHARES U.S. BROKER-DEALERS IAI – – – –
Includes 22 U.S. investment
services stocks with GS and MS
largest holdings.
Health Care
The Health Care sector is a major beneficiary of an aging population and future high levels of health care spending.
MEDTRONIC INC. MDT 16.71 7.78 1.67 AA- *-
Very diverse product line, strong
cash flow, valuation and dividend
support.
S&P/CS
CERNER CORP CERN 33.03 17.02 - -
Leading health information
technology firm is helping to
transform healthcare.
S&P/CS
UNITEDHEALTH GROUP INC. UNH 16.06 10.42 1.37 A+ Leading market position with
product diversity. S&P/CS
JOHNSON & JOHNSON JNJ 18.26 6.95 2.50 AAA AAA rated blue chip with valuation
and dividend support. S&P/CS
MYLAN INC. MYL 13.25 13.15 - BBB- Leading manufacturer of generics
with valuation support. S&P
PFIZER INC. PFE 14.05 2.30 3.35 AA
World’s largest pharma company,
solid pipeline, exposure to
emerging markets.
S&P/CS
VANGUARD HEALTH CARE ETF VHT – – – – Broad exposure from cap-weighted
basket of 293 companies.
ISHARES MEDICAL DEVICES ETF IHI – – – – Cap-weighted basket of 40
manufacturers and distributors.
ISHARES HEALTHCARE PROVIDERS
ETF IHF – – – – Broad-based exposure to U.S.
health care providers.
ISHARES PHARMACEUTICALS ETF IHE – – – – Cap-weighted basket of 36
pharmaceutical companies.
Definitions:
Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters.
Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company’s next full business cycle (typically 3-5 years).
Dividend Yield - Trailing 12-month dividend per share divided by share price.
Credit Rating - Rating assigned by Standard & Poor’s to the long-term obligations of the issuer if repaid in the local currency of the issuer.
(Source: Janney ISG, Bloomberg)
7. Appendix 1: Historical Sector Returns
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Energy
31.5
Energy
31.3
Telecom
36.8
Energy
34.4
Consumer Staples
-15.4
Technology
61.7
Consumer Discretionary
27.8
Utilities
19.9
Financials
28.8
Consumer Discretionary
41.3
Utilities
24.2
Utilities
16.8
Energy
24.2
Materials
22.5
Health Care
-22.8
Materials
48.5
Industrials
26.7
Consumer Staples
14.0
Consumer Discretionary
23.9
Health Care
41.5
Telecom
19.8
Financials
6.4
Utilities
20.9
Utilities
19.3
Utilities
-28.9
Consumer Discretionary
41.3
Materials
22.3
Health Care
12.7
Telecom
18.3
Industrials
40.7
Industrials
18.0
Health Care
6.4
Financials
19.1
Technology
16.3
Telecom
-30.4
S&P 500
26.4
Telecom
6.3
Telecom
6.3
Health Care
17.9
Financials
35.6
Consumer Discretionary
13.2
S&P 500
4.9
Consumer Discretionary
18.6
Consumer Staples
14.1
Consumer Discretionary
-33.4
Industrials
20.9
Energy
20.5
Consumer Discretionary
6.1
S&P 500
16.0
S&P 500
32.4
Materials
13.1
Materials
4.4
Materials
18.6
Industrials
12.0
Energy
-34.8
Health Care
19.7
S&P 500
15.1
Energy
4.7
Industrials
15.3
Technology
28.4
Financials
10.8
Consumer Staples
3.5
S&P 500
15.7
Telecom
11.9
S&P 500
-37.0
Financials
17.2
Consumer Staples
14.1
Technology
2.4
Materials
15.0
Materials
25.6
S&P 500
10.8
Industrials
2.3
Consumer Staples
14.3
Health Care
7.1
Industrials
-39.9
Consumer Staples
14.8
Financials
12.2
S&P 500
2.1
Technology
14.8
Energy
25.1
Consumer Staples
8.1
Technology
0.9
Industrials
13.2
S&P 500
5.4
Technology
-43.1
Energy
13.8
Technology
10.2
Industrials
-0.6
Consumer Staples
7.5
Consumer Staples
22.7
Technology
2.5
Telecom
-5.6
Technology
8.4
Consumer Discretionary
-13.2
Materials
-45.6
Utilities
11.9
Utilities
5.5
Materials
-9.8
Energy
4.6
Utilities
13.2
Health Care
1.6
Consumer Discretionary
-6.3
Health Care
7.5
Financials
-18.6
Financials
-55.3
Telecom
8.9
Health Care
2.9
Financials
-17.1
Utilities
1.3
Telecom
11.5
(Source: Janney ISG, Standard and Poor’s, Bloomberg)
