The stock market has its ups and downs, with a general collective uptrend over the long run. Every investor hopes they can identify future 10-baggers and 100-baggers before they really take off so that they can beat the market, but identifying such stocks in their early stages is difficult as there are usually plenty of competitors that promise the same future and yet are destined to fall flat.
Then there are macroeconomic factors to consider. Growth stocks have a high speculative component to their valuations, so they tend to do well when the economy is booming and poorly in periods of economic trouble and high inflation. Meanwhile, value stocks are more stable throughout the economic cycle as most of their valuations come from real earnings and growth. Some sectors, such as consumer staples and real estate, are known for holding their long-term value well even when the rest of the stock market suffers.
Making bets on specific sectors based on macro factors may seem like an intuitive part of value investing due to the principle of buying low and selling high. However, some well-known value investors disavow market timing as speculation, preferring to focus on company fundamentals and long-term growth prospects instead without regard to the macro situation.
While bets on specific sectors may help protect capital in the short term, timing the market has historically proven to be a difficult endeavor. It is impossible to tell in advance when a bear market will end and the next bull market will begin, which means that holding on to defensive stocks exclusively can lead some investors to underperform if they cannot accurately predict when the market will make a turn for the better.
Would it be better, then, for investors to focus on company fundamentals instead of honing in on specific sectors based on the macro situation? There is no way to know what the future will bring, but letβs take a look at how specific sectors have stacked up against the S&P 500 over the past decade to see if we can identify any patterns.
The most profitable sectors of the past decade
Over the past decade, the S&P 500 ETF Trust (SPY, Financial), an exchange-traded fund that tracks the S&P 500 Index, has achieved an annualized return of 12.02%. Here is how the 10-year annualized returns for the ETFs of the 11 individual sectors in the index stack up, ordered highest to lowest.
Technology Select Sector SPDR ETF (XLK, Financial) ETF β 16.91%
Health Care Select Sector SPDR (XLV, Financial) ETF β 13.75%
Consumer Discretionary Select Sector SPDR (XLY, Financial) ETF β 13.33%
Financial Select Sector SPDR (XLF, Financial) ETF β 11.51%
Industrial Select Sector SPDR (XLI, Financial) ETF β 11.10%
Utilities Select Sector SPDR ETF (XLU, Financial) ETF β 9.91%
Consumer Staples Select Sector SPDR (XLP, Financial) ETF β 9.37%
Materials Select Sector SPDR (XLB, Financial) ETF β 9.06%
The Energy Select Sector SPDR Fund (XLE, Financial) ETF β 4.75%
So we can see that for the past 10-year period, the S&P 500βs technology stocks have performed the best, followed by health care and consumer discretionary. These three were the only sector ETFs that outperformed the index as a whole, which is not surprising considering the S&P 500 is weighted by market cap, so the top holdings have an outsized effect on the overall results.
The worst performers of the decade were energy, materials and consumer staples, though materials and consumer staples were not that far behind the middle of the pack in terms of annualized percentage gains. At a 10-year annualized return of 4.75%, energy was easily the worst performer. Both energy and materials are highly cyclical, though materials has more of a general uptrend due to the increasing global demand for building materials and technology. Even though the consumer staples sector is known for being safer than most sectors in a selloff, it is still not exciting enough in a bull market to garner much attention.
The above results exclude the Real Estate Select Sector SPDR Fund (XLRE, Financial) ETF and the Communication Services Select Sector SPDR Fund (XLC, Financial) ETF, as these are newer additions to the S&P 500 sector lineup and do not yet have as much history as the others. The Real Estate Select Sector SPDR Fund ETF, which was launched in October 2015, has a five-year annualized return of 5.85%, while the Communication Services Select Sector SPDR Fund ETF was launched in June 2018 and achieved a three-year annualized return of 1.48%.
Results from 1999 to the present
For the next part of this study, we will zoom out to the inception of this group of S&P 500 sector ETFs, measuring their annualized gains from the inception date on Dec. 16, 1998 to the present day (nearly 24 years). For comparison, the SPY ETF had an annualized gain of 14.64% for this period.
Consumer Discretionary Select Sector SPDR (XLY, Financial) ETF β 25.97%
The Energy Select Sector SPDR Fund (XLE, Financial) ETF β 22.36%
Health Care Select Sector SPDR (XLV, Financial) ETF β 24.54%
Materials Select Sector SPDR (XLB, Financial) ETF β 19.38%
Industrial Select Sector SPDR (XLI, Financial) ETF β 19.06%
Technology Select Sector SPDR ETF (XLK, Financial) ETF β 16.36%
Utilities Select Sector SPDR ETF (XLU, Financial) ETF β 15.95%
Consumer Staples Select Sector SPDR (XLP, Financial) ETF β 13.86%
Financial Select Sector SPDR (XLF, Financial) ETF β 6.67%
Here, the consumer discretionary, energy, health care, materials and industrial sectors all outperformed technology, which is in large part due to the date range catching the bulk of the dot-com crash, when even those S&P 500 technology stocks that would go on to become long-term winners like Apple Inc. (AAPL, Financial) posted significant losses.
What is truly notable about these numbers is there were only two sector ETFs that performed worse than the SPY ETF: consumer staples and financial. The consumer staples results did not underperform by much, with the real detractor being the financial sector.
Why was the financial sector such a big hit to results? Why did not the performance of the other sectors make up for it? The answer lies with the financial crisis. S&P 500 financial stocks took an enormous hit during the financial crisis, the most notable being Lehman Brothers, which was dropped from the index in 2008 following its bankruptcy, kick-starting a global liquidity crisis. Since the financial crisis, banks have become safer but less profitable.
One more thing I need to note here is that, as you may have noticed, the gains of these ETFs are higher than the S&P 500 index itself. In particular, the SPY ETF has achieved greater growth than the S&P 500 since its inception. This is because ETFs are traded like stocks while indices are not, so there can be a difference between the value of an index and what the market is willing to pay for an ETF that tracks it. The below chart shows how the valuation gap between the SPY ETF and the S&P 500 index has closed over time:
Identifying patterns
The chart below shows how the different sector ETFs of the S&P 500 have evolved over time. Have the winners and losers remained consistent over time, or have they shifted in the long term? What are the short-term patterns?
The biggest long-term shift comes from the energy sector (the XLE ETF, represented in the above chart by the blue line). The global energy situation is constantly changing. Energy is the lifeblood of developed civilizations, and since most of us still rely on non-renewable energy sources, there are a lot of politics at play here based on the locations of the largest oil and gas reserves as well as which nations will begin running out of reserves first.
After that is the technology sector (the XLK ETF, represented by the light green line). This sector rose and fell from 1998 to 2001 around the dot-com bubble and has gained ground rapidly since then. The XLK ETF did not recover from the dot-com crash until 2017, but since then it has boomed, with the bulk of growth occurring after the 2018 correction.
The consumer discretionary sector (the XLY ETF, represented by the orange line) remained the top performer for the most part, with the exception of energy during the shale oil boom. Restaurants, e-commerce companies, automotive aftermarket retailers, entertainment companies and homebuilders all fall under this category. Consumer discretionary spending flourishes when average household disposable income rises.
The financial sector (the XLF ETF, represented by the dark green line) crashed from the fourth-worst performer pre-financial crisis to the worst performer by far afterwards, remaining at the bottom to this day.
Takeaway
Overall, it is clear to see some sectors have performed better than others over the past 20-plus years. While most of the S&P 500 sector ETFs achieved consistent results aside from general stock market crashes, there were some notable exceptions whose price patterns made long-term shifts, such as the energy, technology and financial sectors.
There are two main takeaways from this information. For one, the top-performing sectors have typically kept their status, while the bottom-performing sectors have done likewise. Even if a specific sector seems undervalued in the short term, it is possible it will keep underperforming if it has done so in the past. The second is there have been major long-term sector shifts in the past, so investors cannot discount the possibility other long-term shifts will occur in the future.
