S&P Good Sectors Review

Feb 6, 2024 | Economy & markets, Inflation, Investing, Investment Portfolios, Investments, Markets, Newsletter

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Regular AAC (Asset Allocation Composite), SAA, and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Friday, March 1, 2024. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

S&P Good Sectors Review

We introduced the ‘Good’ S&P 500 sectors on June 7, 2021, through our newsletter titled June 7, 2021: “Good” S&P Sectors. This installment is part of our series of newsletters exploring index funds as businesses. In addition to our perspective of viewing the S&P 500 as a ‘conglomerate’ business, as outlined in the April 1, 2019, newsletter titled April 1, 2019: S&P 500 As A Business, we have delved into various sectors within this ‘business’ in subsequent newsletters: 

As a result, we were able to identify four sectors with strong business fundamentals. In this newsletter, we examine the most recent business metrics for these sectors and subsequently assess the recent performance of the two portfolios based on these favorable sectors.

S&P 500 sector fundamentals

As before, we refer to Yardeni data for the latest (as of Dec 28, 2023) S&P 500 sector fundamentals. 

Observations: 

Healthcare: The healthcare sector, considered one of the four ‘favorable’ sectors, experienced a significant decline in earnings. This can be largely attributed to the substantial earnings surge during the COVID-19 pandemic. This phenomenon can be explained by mean reversion. However, it’s noteworthy that, as of the last quarter, the earnings per share in this sector have been on a downward trend. Therefore, it is crucial to monitor the earnings reports of the healthcare sector closely.

Analyzing the charts above reveals consistently stable earnings per share in the healthcare sector since 2002. With the American population aging, there is an inevitable increase in the demand for healthcare spending. However, it is essential to acknowledge the extraordinary rise in costs within this sector over the past two decades. The escalating costs have become a topic of heated debate regarding how to control them, potentially impacting corporate earnings in the sector.

In terms of revenue, the healthcare sector has exhibited even more consistent and steady growth over the past two decades. The recent decline in earnings should be largely attributed to the escalating healthcare costs, influenced by rising inflation and interest rates. This correlation is substantiated by the sector’s declining operating margins (refer to Yardeni data for more details). 

Despite these challenges, we maintain a positive outlook on the sector and believe that, from a business standpoint, the enterprises within this industry exhibit remarkable resilience in terms of their revenue and earnings.

Consumer Staples: This sector also faced earnings disruptions during the COVID-19 pandemic, which were further exacerbated by inflation and rising interest rates. Unlike the healthcare sector, however, its earnings disruption has predominantly subsided. Since 2022, it has resumed its upward trend.

Information Technology: The tech sector experienced a substantial earnings surge during the COVID-19 pandemic but was later impacted by rising interest rates and inflation. Similar to consumer staples, it has now resumed its upward trend. Demonstrating significant earnings growth, this sector currently accounts for approximately half of the S&P 500 operating earnings per share. A casual examination also indicates that earnings per share in the technology sector have increased nearly 25-fold since 2002. With the recent availability of Artificial Intelligence technology for various applications, its growth prospects remain robust.

Real Estate: We selected the real estate sector as one of the four ‘favorable’ sectors primarily due to its stable cash flow and its comparatively weak correlation to other sectors (except for the financials sector). However, the recent increase in interest rates and inflation has exerted more pressure on this sector’s business than on the other three sectors mentioned above.

In summary, these favorable sectors, excluding Real Estate, have all displayed commendable revenue growth. The fluctuations in their earnings growth or decline can be largely attributed to increasing costs and interest rates. Despite these challenges, these sectors continue to exhibit significantly superior revenue growth compared to other sectors in the S&P 500.

Latest performance of ‘good’ S&P sector-based portfolios

The following table and chart show the latest performance for the portfolios, compared with S&P 500 index fund SPY and a sector rotation ETF: 

Portfolio Performance Comparison (as of 2/2/2024):
Ticker/Portfolio Name Max Drawdown YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
P Composite Momentum Scoring SP Good Sectors 29% 0.5% 17.6% 11.5% 14.8% 13.1% 15.2%
P Composite Momentum Scoring SP Good Sectors Top 1 31% 5.1% 36.6% 12.5% 15.5% 14.3% 16.2%
P SP Good Sector Equal Weight 48% 2.2% 12.6% 8.8% 13.0% 12.3% 14.6%
SPY (SPDR S&P 500 ETF) 55% 4.0% 20.9% 10.8% 14.8% 12.8% 14.9%
SECT (Main Sector Rotation ETF) 38% 2.3% 13.8% 10.1% 13.6%    

In the above, both the Composite Momentum Scoring SP Good Sectors and P Composite Momentum Scoring SP Good Sectors Top 1 portfolios are constructed based on our composite momentum strategy. This strategy involves ranking candidate funds’ price momentum, with the four sectors’ S&P 500 sector ETFs serving as the candidate funds for both portfolios. Additionally, the strategy may switch to CASH if it perceives unfavorable market conditions for risk assets, specifically stocks. The first portfolio selects the top two ETFs out of the four, while the second portfolio opts for the top 1 ETF. Monthly rebalancing is applied.

On the other hand, P SP Good Sector Equal Weight represents a straightforward buy-and-hold portfolio that evenly allocates investments across the four sector ETFs. This portfolio has annual rebalancing.

SECT (Main Sector Rotation ETF) has caught our interest as it appears to yield reasonable returns since its inception. We have included this fund for the purpose of comparison.

Observations: 

The two portfolios based on the composite momentum strategy have consistently outperformed the S&P 500 (SPY) and other benchmarks by substantial margins. In terms of dollar growth, the P Composite Momentum Scoring SP Good Sectors Top 1 portfolio has increased from $1 to $18.5 since 2000, while the Composite Momentum Scoring SP Good Sectors portfolio has grown from $1 to $15. In comparison, SPY and the P SP Good Sector Equal Weight portfolio have experienced growth from $1 to $5 and $6, respectively. Consequently, the two portfolios have surpassed SPY by 3.6 times and 3 times, respectively.

Lastly, the Good Sector Equal Weight portfolio has also exhibited better performance compared to SPY. This once again underscores the exceptional performance of the favorable sectors in relation to the S&P 500 index.

What we learn from the above review is that selecting sectors with strong business fundamentals as a portfolio’s candidate funds can be beneficial. As always, it’s better to be in a good business industry than to be in a company with outstanding management in a tough industry. 

Market Overview

According to Factset, as of December 31, analysts anticipated a 1.5% year-over-year earnings growth rate for the S&P 500 in Q4 2023. By the end of last Friday, with 46% of S&P 500 companies reporting actual results, the blended (year-over-year) earnings growth for Q4 2023 stands at 1.6%, slightly ahead of the expectation. At the moment, we are half way through the earnings report season. 

The most recent inflation (CPI) and payroll (employment) reports continue to indicate a relatively robust economy. This is particularly evident in the employment report for January, where the United States added 353,000 jobs—significantly better than the estimated 185,000. The unemployment rate remained steady at 3.7%, defying the estimated rate of 3.8%. Additionally, wage growth demonstrated strength, with average hourly earnings witnessing a 0.6% increase, twice the monthly estimate. On a year-over-year basis, wages experienced a substantial surge of 4.5%, well exceeding the forecasted 4.1%. This has raised investors’ concerns about the potential resurgence of inflationary pressure and heightened interest rates. Stocks have encountered a degree of volatility as a result.

As always, we claim no crystal ball and we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as we have emphasized numerous times when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years, preferably much longer, given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially during this time. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This is true time and time again.

Stock valuation has dropped, and now valuation is becoming less hostile. However, it is still not cheap by historical standards. For the moment, we believe it’s prudent to be extra cautious. However, how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of market is through dollar cost average (DCA), i.e., invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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