S&P 500 Sector Recommendations

Summary

• We provide our major sector allocation recommendations for the S&P 500 and ETFs associated with each sector.
• Unsurprisingly, our allocations largely follow the growth versus value theme that has dominated the market this year.
• Our basic methodology is to over- or under-weight sectors based on our evolving macro views and expectations of whether they will out- or under-perform the broader S&P 500.

Market Implications

• The largest sector by far is technology, with a 27% share of the S&P 500 market cap. Therefore, outperforming the S&P 500 is largely about getting the technology call right.

Introduction

We expand our ETF recommendations to include the major sectors of the S&P 500. Full disclosure – investing in 2022 (at least so far) has been primarily about growth versus value, not sectors (Chart 1). Still, on a market-cap basis, many sectors do have either a growth or value tilt (Chart 2).^[1]

In this report, we summarise the rationale for our sector allocation. In coming weeks, we will publish more detailed analyses of each sector.

Our Asset Allocation Approach

In making these sector allocations, we are expressing a view on whether each sector is likely to out- or under-perform the S&P 500 in coming months, based primarily on our evolving macro views.

Generally, we are not looking to trade on short-term technicals. Furthermore, these views are not about which sectors are likely to make or lose money outright, or which perform the best or worst. Each sector has its own set of investment characteristics and risks, and investors have different preferences about how they want to position themselves.

Some Fun Facts and Figures

Some other points are worth recognising in an asset allocation exercise. One is the relative weightings of each sector (Chart 3). It is immediately apparent that Technology is the dominant sector, with a 27% share. Four sectors are in the 10% range, while Energy, Materials, Real Estate, and Utilities under 5%.

You could be forgiven for thinking that outperforming the S&P 500 is largely about getting the Technology sector call right and simply being slightly over- or under-weight the other sectors (so the total weights add up to 100%).

On a year-to-date basis, returns across sectors vary widely (Table 1). Energy is the standout, up 37%. Utilities is up a robust 7.5%. And the Growth-oriented sectors (Communications, Consumer Discretionary and Technology) are all down more or less 15%.

But look at the relative contributions of each sector to the S&P 500’s return of -7.4%. Technology contributed more than twice Communications or Consumer Discretionary. Together, these three sectors contributed -7.7 percentage points. Despite their high absolute returns, Energy and Utilities together offset this by a very modest 1.6 percentage points.

Our Allocation Rationales

Communications: Underweight

Communications is highly diverse. It includes FANGs Google (GOOG) and Netflix (NFLX), Disney (DIS), cable companies, and old-line telecoms like Verizon (VZ) and AT&T (T). On an equal-weighted basis, it would easy to market-weight this sector. But given that it is 75% growth oriented on a market-weight basis, we underweight Communications versus the S&P 500.

Sector ETF: XLC

Consumer Discretionary: Underweight

This is also a tough one to pin down. The big ones are Amazon (AMZN) and Tesla (TSLA). Then there are restaurant chains like McDonalds (MCD) and Starbucks (SBUX), homebuilders, old-line auto manufacturers like Ford (F) and General Motors (GM), and brick-and-mortar retails like Best Buy (BBY) and Target (TGT). Again, because of the heavy growth orientation we underweight Consumer Discretionary for now.

Sector ETF: XLY

Consumer Staples: Market Weight

Consumer staples usually tracks the S&P 500 closely. As long as growth continues to underperform, consumer staples should outperform the S&P 500.

Sector ETF: XLP

Energy: Overweight

Despite its sterling year-to-date performance, we recommend overweighting Energy. In part, we expect oil prices to stay near $100 for some time. But more importantly, energy companies are turning away from heavy CAPEX and exploration to focusing on profitability and returning capital to shareholders. There is some risk that oil and gas companies will ramp up exploration and production due to the Ukrainian war and public policy pressure, but this will surely be temporary.

Sector ETF: XLE

Financials: Overweight

We recommend overweighting financials because financials are trading well below normal levels relative to the broader S&P 500. With markets more focused on value, we expect financials to gradually recover.

Sector ETF: XLF

Healthcare: Market Weight

Healthcare tends to closely track the broader S&P 500. With a company mix slightly tilted to growth (on a market-cap basis), we recommend a market-weight position.

Sector ETF: XLV

Industrials: Market Weight

Industrials are modestly tilted to value. But the sector faces challenges from rising commodity prices and supply-chain problems. On balance, we recommend a market-weight position.

Materials: Overweight

Materials should benefit from high commodity prices. We recommend an overweight position.

Sector ETF: XLB

Real Estate: Market Weight

The real estate sector is primarily REITs. They are attractive to some investors because of high dividends. With rising rates, dividend streams become less valuable. But the US is also facing a major housing shortage. To the extent REITs are converting excel retail space to residential, they will benefit from still-rising home prices and rents. On balance, we recommend a market-weight position.

Sector ETF: XLRE

Technology: Underweight

Given the technology sector’s strong growth tilt, we recommend an underweight position for now.

Sector ETF: XLK

Utilities: Market Weight

Utilities have unquestionably benefited from the shift to value, and that should continue. However, utilities will also face pressure from rising rates on two fronts. Dividends will become less valuable, and they rely on debt to maintain payouts. With rising commodity prices, raw materials will also be more expensive. We recommend a market weight position.

Sector ETF: XLU

ETF Summary

The table below summarises ETFs that have been designed to track each S&P 500 sector.

[1] When we count companies by sector (i.e., on an equally weighted basis), most sectors are roughly split between growth and value. Only Information Technology is heavily growth, and only Utilities is mostly value.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)