Some retail investors treat the stock market like a tooth fairy. They simply place their hard-earned money, not teeth, in the stock markets and wish or hope for the best while fast ASLEEP! They base their stock picks on hype and news about the hottest stocks and so on, unaware that once widely accepted, most news-based insights lose their ‘edge’. In other words, they are likely trying to board a train that is either at its final stop or close to it. There are a plethora of reasons why this usually does not work but this article will focus on one and shed light on what you can do to improve your investment choices.
When investing in stocks, it is advisable to focus on buying good companies and not just share prices on a screen, however even good companies can go through a prolonged lull period, just ask those, including Nancy Pelosi, who bought TESLA, APPLE, META and the likes seven months ago. This does not make them bad companies, they just happen to be sensitive to inflation, the Federal Reserve’s inevitable rate hikes, and other macros.
Of course, how long you are willing to hold is a factor to consider but I have come to realize that people fall back on the excuse of ’Oh this one is a long hold’ to cover up their folly instead of digging deeper. Most people actually do not think it is possible to time the markets due to their bad experiences and misinterpreted cryptic advice from gurus and ‘seasoned’ investors. Not everyone can invest like Warren Buffet! However, we can use some of the tools he and others like him use to evaluate the markets they invest in. Put together from many decades of research, such tools are no longer the domain of only institutional investors like Black Rock and Vanguard, individuals can now use them effectively as well.
So how does one pick the right stocks if you can get burned picking even strong companies with good internals? One needs to first understand that there will always be periods of drawdown but those can be managed by cutting losses quickly and doubling down on what is working. In other words, good risk management. Now that we have gotten the common sense part of things out of the way, let us take a look at some very interesting realities of how institutional investors rotate their positions across asset classes depending on what is happening in the macroeconomic environment or ‘business cycle’ as they like to call it.
Sector Rotations
Sector rotation investing is simply about using a top down investment strategy that identifies specific sectors and subsectors that are expected to outperform at certain points in changing market cycles. As investor focus and business conditions change due to macroeconomic situations, investors can rotate the stocks and ETFs they hold in their portfolio.
| Sector | Early | Middle | Late | Recession |
| Financials | + | |||
| Real Estate | ++ | — | ||
| Consumer Discretionary | ++ | – | — | |
| Info – Tech | + | + | — | — |
| Industrials | ++ | |||
| Materials | + | — | ++ | |
| Consumer Staples | ++ | ++ | ||
| Healthcare | — | ++ | ++ | |
| Energy | — | ++ | ||
| Communications | + | – | ||
| Utilities | — | – | + | ++ |
The table above groups the different sectors in the stock market according to how they perform in the four market/business cycles. These cycles are catalyzed by various factors but most important among these factors is inflation and interest rates, which is dictated by the Federal Reserve.
Typically, growth sectors like tech do well in expansion phases of the economic cycle. Tech is very sensitive to inflation and such is not a good sector to hold in the late expansion phase nor during recessions. Defensive sectors like consumer staples are a better fit for difficult times as they are more resilient during periods that the Fed is tightening the purse strings. Consumer discretionary stocks also suffer during the late growth and recession phases as consumers prioritize more stringently during these periods.
It is important to note that sectors that do well in the expansion phase usually pay high dividends but investors still drop them for safer sectors that pay lower but steadier dividends in hard times. Armed with this information, investors may perhaps now see why sometimes it could make sense purchase a boring water bottling company or a food company rather than Apple, Tesla or even Snap Chat shares. The terms growth sectors and defensive sectors are used to describe both sides of this spectrum.
Investing in ETFs
An ideal way to invest in sectors is to hold a diversified mix of stocks representative of each of the sectors. However an easier way to do this would be to simply buy shares in a sector mutual fund or ETF. Sector mutual funds come in different forms, some are actively managed and others are designed to parallel a particular sector benchmark — so-called index funds. ETFs go a step further, offering the low fees of index funds and the agility of stocks.
How do ETFs work? Institutional investors deposit blocks of securities in funds. These baskets of stocks reflect the composition of indexes such as the Nasdaq 100 and the S&P 500. Shares of the fund are then listed on exchanges. These ETFs can then be bought and sold in real time at prices that change throughout the day. Investors can use them for different strategies such as hedging by selling short or even buying on margin. Below are the list of index ETFs available on most exchanges.
- Financials (XLF)
- Real Estate (XLRE)
- Consumer Discretionary (XLY)
- Info-Tech (XLK)
- Industrials (XLI)
- Materials (XLB)
- Consumer Staples (XLP)
- Healthcare (XLV)
- Energy (XLE)
- Communications (XLC)
- Utilities (XLU)
Here are the top 10 holdings of the various sectors discussed above.
XLF
Berkshire Hathaway Inc. Class B
JPMorgan Chase & Co.
Bank of America Corp
Wells Fargo & Company
Morgan Stanley
S&P Global, Inc.
Charles Schwab Corp
Goldman Sachs Group, Inc.
BlackRock Inc.
Citigroup Inc.
Total Weighting – 52.98%
XLRE
Prolongis Inc.
American Tower Corporation
Equinix Inc.
Crown Castle Inc.
Public Storage
Realty Income Corporation
Simon Property Group Inc.
Welltower Inc.
VICI Properties Inc.
SBA Communications Corp. Class A
Total Weighting – 62.02%
XLY
Amazon.com, Inc.
Tesla Inc
Home Depot, Inc.
Nike, Inc, Class B
McDonald’s Corporation
Lowe’s Companies, Inc.
Starbucks Corporation
TJX Companies Inc
Booking Holdings Inc.
Target Corporation
XLK
Apple Inc.
Microsoft Corporation
NVIDIA Corporation
Visa Inc. Class A
Mastercard Incorporated Class A
Broadcom Inc.
Cisco Systems, Inc.
Accenture Plc Class A
Adobe Incorporated
Texas Instruments Incorporated
Total Weighting – 66.94%
XLI
Raytheon Technologies Corporation
Honeywell International Inc.
Caterpillar Inc.
United Parcel Services, Inc. Class B
Union Pacific Corporation
Boeing Company
Lockheed Martin Corporation
General Electric Compay
CSX Corporation
Total Weighting – 41.31%
XLB
Linde plc
Air Products and Chemicals, Inc.
Freeport-McMoRan, Inc.
Sherwin-Williams Company
Corteva Inc
Newmont Corporation
Dow, Inc.
Nucor Corporation
Ecolab Inc.
Dupont de Nemours, Inc.
Total Weighting – 63.43%
XLP
Procter & Gamble Company
Coca-Cola Company
PepsiCo Inc.
Costco Wholesale Corporation
Philip Morris International Inc.
Walmart Inc.
Mondelez International, Inc.
Altaria Group Inc.
Estee Lauder Companies Inc
Colgate-Palmolive Company
Total Weighting – 69.60%
XLV
UnitedHealth Group Incorporated
Johnson & Johnson
Merck & Co Inc.
Eli Lilly and Company
AbbVie, Inc.
Pfizer Inc.
Thermo Fisher Scientific Inc.
Abbott Laboratories
Danaher Corporation
Bristol-Myers Squibb Company
Total Weighting – 54.17%
XLE
Exxon Mobile Corporation
Chevron Corporation
Schlumberger NV
EOG Resources, Inc.
ConocoPhillips
Marathon Petroleum Corporation
Pioneer Natural Resources Company
Valero Energy Corporation
Phillips 66
Occidental Petroleum Corporation
Total Weighting – 74.67%
XLC
Meta Platforms Inc. Class A
Alphabet Inc. Class A
Alphabet Inc. Class C
Verizon Communications Inc.
Netflix, Inc.
Walt Disney Company
Charter Communications, Inc. Class A
Comcast Corporation Class A
T-Mobile US, Inc
AT&T Inc.
Total Weighting – 75.62%
XLU
NextEra Energy, Inc.
Duke Energy Corporation
Southern Company
Dominion Energy
Sempra Energy
American Electric Power Company, Inc.
Exelon Corporation
Xcel Energy Inc.
Consolidated Edison, Inc.
Public Service Enterprise Group Inc.
Total Weighting – 60.21%
Some companies are listed on more than one ETF under different classifications due to their multiple business functions.
There are ratios you can develop by dividing the percentage gains of growth funds by those of defensive funds. For example, if investors are rotating heavily out of XLU into XLK, you would typically expect to see a market rally, short term or otherwise. This rotation is one of the signatures you should expect to see in a low inflation, declining interest rate, bullish, risk on environment. There are other factors to consider when making investment decision but asking questions like this are a very good starting point.
In my next article about sector rotations, I will dive into the details of how to use certain ratios to improve the timing of your investments in the capital markets.