Articles

Sectors And Style
By Paul Baiocchi and Paul Britt

Related ETFs: IYM / VAW

Page 3 of 9

Sector Performance
The goal of any classification system is to create distinct subsets that move differently from one another. If the divergence in performance between different sectors is great, it will support the case for sector analysis as a useful way to parse the market. If the differences are muted, the opposite holds true.

Figure 3 shows the discrepancy between the best- and worst-performing sectors over different time frames, and as you can see, the divergence has been huge. Over the past year, the difference between the best- and worst-performing sectors—telecom and energy, respectively—was 23 percent. Over the past 15 years, the difference between the best (energy) and worst (financials) return was 277 percent.

Time Period Returns Sectors

While some might argue this highlights the case for long-term buy-and-hold sector strategies, it actually forms the basis of a case for more tactical sector use. That is supported by the widely variable year-by-year performances; the leader in one year can and does become the laggard in the next. Figure 4 shows just how much these results can vary year to year. Here we have the annual performance of each sector from 2002 to 2012 with each year's best performer highlighted in green and the worst performer highlighted in red. Over the past 10 years, each sector, with the exception of utilities and industrials, has represented either the best or worst performer at least once. This further underscores the distinctive performances offered by sectors.

Yearly Returns Sectors

Of course, the performance of each sector provides little information without proper context, which is where correlation comes in (see Figure 5).

S&P 500 Sector 5-Year Monthly Correlations

Over all time frames studied, there have been consistent intersector correlation patterns. For example, over the past year, utilities firms have shown very low correlation to basic materials and technology firms, and muted correlations to consumer discretionary stocks. As the time frame expands, utilities show decreasing correlations to all sectors. In fact, over the past five years, the average correlation between sectors is just 0.68.

At the same time, the elevated correlations between some sectors also highlight how properly defined sectors will show logical economic relationships. Consumer staples and health care firms—two defensive sectors—have shown high correlations to each other, and are the only two sectors that have shown average or better correlations to utilities. These sectors are all less dependent on high rates of economic growth than, say, the industrials or consumer cyclicals sectors.

The convergence of returns among the more cyclical sectors of the market—technology, materials, consumer discretionary and industrials firms—are much more dramatic. Not only are correlation pairs between these sectors above average, they reach as high as 0.911 (industrials and consumer discretionary).