Investors are bombarded with news about how well (and poorly) individual companies perform and how well groups of companies that share similar business characteristics might perform given certain economic environments.
Unfortunately, many use the terms “sector” and “industry” incorrectly and it’s important to understand the differences between the two, because what many refer to as “an industry” is actually “a sector.” While it might sound like splitting hairs, it’s not, as financial advisors are more apt to focus on sectors as an additional diversification tool.
Creating Categorizations of Companies
The global economies and by extension each of the stock markets within and all publicly traded companies, are essentially organized into hierarchical levels:
- At the highest level we find 11 groups of similar companies called sectors;
- Below the 11 sectors we find 24 industry groups;
- Below the 24 industry groups we find 69 industries; and
- Below the 69 industries, we find 158 sub-industries.
As we move down the hierarchical pyramid, the characteristics of the companies within the groupings become tighter. In other words, two companies categorized within the same sub-industry share more economic characteristics versus two companies categorized in the same sector.
Sectors Can Help Diversification
Financial advisors examine historical sector performance and analyze how companies are organized into different industries because both are important tools when building diversified portfolios for clients.
The reason is that because over every single time period, sector performance is driven largely by factors one would expect, such as the overall state of the economy, underlying corporate earnings, current and predicted interest rates, and inflation, among other factors. And financial advisors know that reviewing sector performance on a monthly, quarterly, semi-annually and yearly basis proves one thing:
- Sectors do not move in lock-step with one another and will often provide very divergent returns for investors – depending on timing and the current economic climate
The S&P 500
The S&P 500, sometimes simply called the S&P, is a stock market index that represents the collective performance of 500 publicly traded, large-cap companies in the U.S. (ok, technically there are 505, but let’s talk about that another time). Representing about 80% of the U.S. equity market, the S&P 500 is one of the most often-cited proxies for the U.S. stock market.
Introduced in 1957, the S&P 500 is maintained by S&P Global and in order for a company to be included in the S&P 500, it must meet certain criteria, including:
- Be in the U.S. with an unadjusted market cap of at least $8.2 billion
- At least 50% of its stock must be available to the public
- It must file a 10-K annual report
- Have at least four consecutive quarters of positive earnings
- Be listed on the New York Stock Exchange, NASDAQ, Investors Exchange or BATS Global Markets
The 11 S&P 500 Sectors
Each of the companies within the S&P 500 is categorized into one of 11 sectors and for most of them, the name of the sector says it all:
Information Technology sector contains companies that develop or distribute technological items or services.
Health Care sector contains companies that develop or distribute medical supplies and pharmaceuticals.
Financials sector contains companies involved in finance and investing.
Consumer Discretionary sector contains companies that develop or distribute products that are considered luxury items (not needed to survive).
Communication Services sector contains companies that allow us to communicate – internet and phone providers, media, and entertainment companies.
Industrials sector contains a broad swath of companies, including airlines, construction and railroad companies.
Consumer Staples sector contains companies that are needed to live (the opposite of consumer discretionary). Think food and beverage companies.
Energy sector contains companies that are in the oil and gas business in some way.
Utilities sector contains companies that provide electricity, water and natural gas to consumers and businesses.
Real Estate sector contains Real Estate Investment Trusts, realtors, home-builders and similar companies.
Materials sector contains companies that provide raw materials, like copper, zinc and paper.
The Percentage of Each Within the S&P
The percentages of each sector within the S&P 500 as of the end of June is as follows:
- Information Technology: 24.4%
- Health Care: 14%
- Financials: 12.2%
- Communication Services: 10.7%
- Consumer Discretionary: 9.9%
- Industrials: 8.9%
- Consumer Staples: 7.2%
- Energy: 3.6%
- Utilities: 3.5%
- Real Estate: 3.1%
- Materials: 2.5%
Why Sectors Matter
As evidenced in the first six months of 2020, the relative performance of each sector tends to rotate as the overall economy shifts from one business cycle to the next. But this is not a phenomenon that is new – sectors have always rotated from performance leaders to performance laggards based on structural shifts in the economy.
For example, some sectors are considered more sensitive to interest rate movements – financials, real estate and consumer discretionary.
Other sectors are considered more economically sensitive, meaning they do better when moving from recession to recovery – industrials and information technology for example.
Some sectors are considered more defensive, like utilities and health care.
Sector Performance in 2020
The overall trend for sector performance in 2020 has been mixed, as performance leaders and laggards have rotated all year.
You might remember, for example, that in the first quarter of 2020, all 11 S&P 500 sectors were negative, whereas April saw all of them positive, the month of May saw most of them positive and June saw less than half of them positive.
Reviewing the sector returns for the second quarter and YTD through June 30, 2020, we saw that:
- Every single one of the 11 S&P 500 sectors was positive for the second quarter of 2020
- The Utilities sector was the worst performer for the second quarter as it barely crept into positive territory
- The differences between the best performing and worst performing sectors in Q2 were dramatic, with three sectors (Consumer Discretionary, Information Technology and Energy) up more than 25x the Utilities sector
- On a YTD basis, the differences between the best and worst performing sectors is just as dramatic, with a difference of over 50% as Information Technology sector is up over 14%YTD and Energy is down a whopping 37%
Here are the sector returns for shorter time periods through the end of June 30, 2020:
Knowing which sectors have historically performed well during certain market environments is just as important as knowing which ones have performed poorly in certain environments.
Your financial advisor can help you better understand how and when to use sectors within your overall asset allocation.
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