Demystifying Market Sectors

With all of the hoopla over various stock indices, it is sometimes easy to forget that the stock market is a market for individual stocks and not a singular entity that eats fortunes.  These stocks are not merely little pieces of paper (or the digital equivalent); they represent discrete pieces of ownership in living, breathing companies. These companies, taken collectively, do everything under the sun for which people will pay money.  Some stocks represent banks and other financial companies. Some stocks represent restaurants. Some represent clothing stores. Some represent mining, and some represent drilling for oil. When investment experts talk about sectors, they are talking about groups of stocks that have underlying businesses engaged in the same sort of income generating activities.

Because these companies do the same basic thing, they are subject to similar economic forces.   Sectors tend to rise together when economic conditions are good for those types of companies and fall together when economic conditions are bad.  For the investor, this means that poor sector performance can mean poor portfolio performance if you are not diversified across not only different stocks but different sectors of stocks.  Take the financial sector for example. If interest rates are on the rise and all of your investments are in bank stocks, then your whole portfolio will likely rise. If interest rates are cut, then your whole portfolio stands to plummet.  For the individual investor, the best advice is probably to buy the best of breed stocks across as many different sectors as you can.

In the United States, the most common system that you will see for sector classifications is the one used by Nasdaq.   Nasdaq uses the ICB (Industry Classification Benchmark) which is maintained by the FTSE Group. This system uses a hierarchical approach in which there are ten “industries” at the topmost level, 19 “supersectors” below that, and 41 “sectors” below that, and the fourth level with 114 “subsectors.” (You can download an Excel spreadsheet of this information from  http://www.icbenchmark.com/structure)  Be aware that these sector classifications may change depending on which information service you use.  When I look up the symbol TST on TD Ameritrade, it tells me that it is classified as “Financials: Capital Markets.”  When I look it up on Yahoo! Finance, I find that it is classified as being in the “Internet Information Providers” industry and in the “Technology” Sector.

There are several indices and ETF (Exchange Traded Funds) that are sector based, allowing you to invest across a wide swath of stocks in a particular sector.  The sector ETFs are like broader index funds that only provide exposure to one sector rather than the entire market. Understanding a particular sector is important when picking stocks.  Different businesses measure success in different ways, and if you don’t know how to tell if a particular breed of business is successful, you obviously shouldn’t speculate in that sector’s stocks.  

A great way to find information about investing in a particular sector is to read the research done by high-quality research and investment firms, and of course by following the sector on TheStreet. Always remember that the fortunes of individual stocks are tied to sector evaluations, largely because of these behemoth sector funds.  Perfectly solid companies with a stellar trajectory can take a huge hit if investors (especially the big institutional ones) dump the entire sector, just as they can when there is an overall market decline like the Great Recession. If you have done your homework, evaluated the fundamentals, and have conviction about the company’s story, then sector selloffs present an important buying opportunity.

Demystifying the Financials Sector

Stock market analysts often worry about market volatility, which is jargon for a rapid cycling of upward and downward trends in a particular stock, sector, or index. Some intrepid traders use this sort of volatility to capitalize on very quick downturns to buy and quick upturns to sell. This strategy is considered very dangerous and full of risk by most long-term investors. They view it as something akin to playing roulette.

Many day trading strategies exist to help these brave traders make these volatility based plays. The long-term investors hate volatility because it makes the market less certain and picking stocks more difficult. As you may have predicted, the financial services sector is prone to high levels of volatility. The reason that everyone doesn’t avoid high volatility stocks and stock sectors? Great risk often equates with great reward in the stock game.

If a company is in the business of handling other people’s money, then it likely fits into the financial industry. Banks, insurance companies, real estate companies, and financial service companies are the major supersectors in this industry. To get an understanding of exactly what makes stocks rise and fall in this industry, you must have a grip on each of the subsectors.

As a general rule, financials perform best in a low-interest rate environment, but that statement must be qualified. The value of long-term debt such as mortgages is higher when interest rates are lower. In periods of low-interest rate mortgages (and other long-term debt), the general rule will not hold. The complex interaction of current interest rates and long-term interest rates are part of what makes this sector so potentially volatile.

When the business cycle is on the upswing, and there is a high level of confidence in the economy, both individuals and businesses seek to expand wealth. This is often accomplished through growth, which means that these individuals and corporations need financing. Businesses build and replace infrastructure, and individuals increase personal savings and investing.

These are heady days to be invested in the financial sector! Financials make up a large portion of the S&P 500, consisting of household names like Bank of America, Citigroup, and JP Morgan Chase. If you were invested in these financials at the beginning of the Trump Rally, you fared very well! (See a chart for November through December of 2016 for Goldman Sachs Group Inc. (GS) if you are a visual learner). Investors can’t afford to become complacent given these meteoric rises in equity. Never forget the devastating losses to this sector when the real estate bubble burst in 2008.
Several investors use the Financial Select Sector SPDR ETF (XLF) to track the overall health of this sector.

The volatility of that index has been quite low over the past three years (Beta = 0.93), debunking the notion that financials is a volatile sector that should be avoided by prudent investors. History teaches us that the sector’s volatility can, however, increase dramatically during uncertain economic times. In this sector, the prudent investor will shy away from a “buy and hold” strategy. The correct strategy is to follow the advice of Mr. Cramer: “Buy and Homework.” That homework must include drilling deep into the underlying business and inspecting the balance sheets before you pull the trigger. It also means tracking the larger economy, with a special emphasis on what the Fed is doing with interest rates.


Demystifying the Oil and Gas Sector

As with most of the industries and sectors that stock investors may seek to invest in, the oil and gas sector is often intimidating because of the massive amount of jargon that is involved.  Another layer of complexity is added by the global nature of the oil market and the political nature of international relations in historically volatile regions. It is important to realize that oil and gas are commodities.  Supply and demand economics rules commodity prices. When there is a surplus of oil or gas, prices tend to go down. When demand is high, and supply is too low to meet it, then prices climb sharply. These fluctuations in commodity prices have an enormous impact on the bottom line of companies in this sector.  

Oil and gas are sometimes referred to as hydrocarbons because of their shared chemistry.  They are commonly referred to as “fossil fuels” because of the way they originated. The basic idea is that ancient plant and animal life were covered over by sediment, and this sediment later formed into rock.  Add a few million years, and presto: you get natural gas and crude oil. The first thing this tells us is that oil deposits are hard to find because they are in the ground, buried under hundreds or thousands of feet of rock.  In the case of offshore deposits, you can’t even get to the rocks without going through hundreds of feet of water. The sector that is most closely associated with finding the oil and gas in the first place is usually called exploration.   This exploration and production end of things are dangerous; if the geologists get it wrong and the hole is dry, then many millions of dollars have been wasted.  Many of these companies take the raw commodities out of the ground and turn them into the useful products, such as gasoline, that people want to buy; this is most often referred to as refining.  Some companies get involved in the retail and distribution end of oil and gas as well, and these companies are usually classified in the “Integrated Oil and Gas” sector.  

Another important sector in the oil industry is the “Oil Equipment, Services, and Distribution” sector.  Getting millions and millions of gallons of oil and natural gas refined and to retail markets is a massive undertaking.  Many companies provide tools, equipment, chemicals and so forth to the oil exploration and production companies. E&P companies often farm out the actual drilling of the wells to drilling companies.  Drilling companies earn profits based on contracts and are not tied directly to the price of oil as are the E&P companies. Most such companies get lumped together into the “Oil Equipment and Services” subsector, but “Pipelines” are such a big deal that they get a subsector designation.

Most of the companies that explore for oil and gas also drill down to find it and bring it to the surface, a process called production.  Exploration and Production (E&P) company stocks sell at a premium when oil prices are high, and tend to sell at a discount when oil prices are low.  The balance sheets of these companies are composed of line items directly related to drilling for oil and gas and getting it out of the ground once it is found.  This means that investors in this sector must be familiar with the terminology and jargon of E&P as part of their homework on investing in the “oil patch.” As with any commodity, profits are made by volume of sales.  Wheat and corn sell by the bushel, and oil sells by the barrel (42 U.S. Gallons). Natural gas, on the other hand, is sold by the Cubic Foot (at a standard temperature and pressure).

Another important set of jargon you need to understand before investing in the oil patch is the difference between upstream, midstream, and downstream.  The term “upstream” is used to refer to the source of the oil or gas; the E&P side of things. The midstream is focused on storage and transportation. Finally, the downstream side refers to the refining and distribution of refined products.  For example, a drilling rig in Alaska would represent an “upstream” activity. The transportation of the oil from that well via a pipeline would be midstream activity. The refining and sale of gasoline would be downstream activity. These distinctions are important because they provide different potential risks and rewards for the investor.       

Just as with any other company, the value of an E&P company stock is directly related to its predicted future earning capacity.  These companies have a finite amount of oil or gas that they can pull out of the ground given all of the wells they have currently producing.  These still in the ground reservoirs are key to the valuation of E&P companies. Oil companies must always be exploring for new reserves or face bankruptcy.  Note that reserves in the oil patch are different than a company’s expected earnings.

Curiously, oil patch investors pay close attention to the “netback.” or profit per barrel of a particular production operation.  That is what it costs to get a barrel of oil to the retail market is subtracted from what the products sold for. Companies with a higher netback tend to sell at a premium while companies with a low netback tend to sell at a discount.  Netback rises when costs can be cut at any point from initial exploration to the final sale at the gas pump. These factors have historically been very predictable, with the American oil industry suffering when the sale price of a barrel of oil was low.  If it takes an American company $75 to get a barrel of oil to market and the price of oil is at $50, then obviously these companies cannot be profitable on the domestic side of the business.

Technology has already played a major role in improving the viability of American E&P companies.  We have become better at finding oil and gas, we’ve gotten better at getting it out of the ground, and we’ve become more economical at getting it to market.  When American E&P CEOs are telling investors that they can make a comfortable profit in the $45 per barrel range and oil is selling at $50, then it is a potentially exciting time for investors.

Note that the “Oil and Gas” industry would probably have been better named the “Energy” sector, and that’s what a lot of investors call it.  One reason for this is the fact that the “Alternative Energy” sector is within the “Oil and Gas” sector, creating an oxymoron. When we talk about “Alternative Energy” we are talking about alternatives to oil and gas.  The two major subsectors in this sector are “Renewable Energy Equipment” and “Alternative Fuels.”

Most companies tied to solar and wind will be tied to the equipment subsector, and oil and gas alternatives such as ethanol and fuel cells will be tied to the fuels subsector.  Most of the companies in this sector are very speculative and not suitable for the long-term value investor. So long as crude is selling for $50 or less, then the alternative sector has a long way to go before it can become broadly competitive. During periods of “environmentally friendly” politics and policy, government incentives make this sector seem more attractive.  During periods of pro-business policy and deregulation, oil and gas will be king, at least for the foreseeable future.


Safety Trade is Getting Dangerous

The Russell 2000 small-cap index is up nearly 11% so far this year, while the venerable old S&P 500 is up only around 5%.  The disparity is due largely to the trade war, and investors have bought the stocks of small capitalization American companies with great vigor.  The normal correlation between markets has been tossed out, it seems, and the relationship has turned inverse. Anytime the S&P 500 looks weak, the Russell 2000 has a good day.  Investors are forgetting a few things about business economics, and that is a very dangerous mistake to my way of thinking. One thing we need to remember is that small companies have supply chains just like large companies, and these are rather limited in comparison.  

We are essentially blind when it comes to knowing where what companies get what materials.  If a small knife company in Wisconson needs a certain type of steel, the can’t be too picky where they get it, and they don’t have the bargaining power to drive the price down.  They will pay the market price. If GM and Ford are having problems with the plentiful steel that car parts are generally made with, we can only imagine the trouble that small manufacturers that require specialized materials are having.  What percentage of the small-cap supply chain is dependent on our foes in the trade war? Estimates abound, but these are largely derived using the SWAG method and are no basis for careful analysis.

Another key issue is margin expansion due to increased demand.  If investors are flooding into small-cap stocks, there aren’t enough to go round.  This drives prices up substantially, and those already in the space have a great year (so far).   As much as it pains me to admit, the vicissitudes of politics do have a huge impact on the valuation of companies, both large and small.  With the 2018 midterm elections on the horizon, the political pressure is on to demonstrate to the world that the GOP is indeed Making America Great Again.  

Regardless of how good the deals we can get really are, I predict a massive streak of deal signing and a commensurate amount of back patting and acclaim that the deals are great.   Democrats will attack the deals as smoke and mirrors. The truth, as always, will be somewhere in the middle. Regardless o how good the deals are, it will have a calming effect on Wall Street as the uncertainty level drops.  When that happens, traders will see that the small caps have run, and there will likely be a rotation back into large-cap multinationals that have been hurt by the trade war.

I don’t mean to retract my previous predictions that we are nearing a downturn in the broader economy and a big scary pullback in equity prices.  I do, however, agree with Ray Dalio’s timeline and think it is a bit premature to start yelling that the sky is falling. There is a high probability that we’ll see a bit more euphoria and another big rotation before a broad downturn occurs.  I think the next big boom will be back into the out of favor sectors damaged by the trade war, so the industrials and emerging markets will have a few days in the sun.

Regardless of where the money goes, it will come out of small caps. The more I hear watercooler talk of getting into the small-cap space the more I think that the space is overbought.  I recommend getting out of the space and looking toward the beat up sectors, especially emerging markets. I also like Canada and the financials at this stage.

With the FANG earning season in shambles, there may be a sale in tech in the near future.  I would wait for a massive pullback before entering that space as it has flown to amazing heights.  Big moves from recent values don’t necessarily reflect meaningful moves relative to fair valuations.  I am very wary of the upward move in Amazon as the EPS move was truly spectacular, but revenues were essentially flat.  Letting large sums flow down to the bottom line doesn’t tell a growth story, it tells a story of maturity. Amazon may be the retail business equivalent of a bulldozer, and we need to remember that bulldozers aren’t nimble.

I recently closed out my leveraged biotech position, and am holding financials and energy.  I’m short both the Russell 2000 and the S&P 500. I’m also sitting on a lot of cash, waiting on that sale.

 


You may also be interest in a section of my book entitled Take Some Off the Table.

Index Investing With SPDRs in Volatile Markets

Many financial experts and Titans alike recommend index investing as a strategy that will get the average investor what John Bogle calls “your fair share of the market’s return.”   A common strategy is to buy an S&P 500 mutual fund, usually through a “constant dollar investing” strategy inside a 401(k) or similar tax-sheltered retirement account. This will work over the long term if we are spared the apocalypse, but it may not be the most efficient way to go about it.   One option is to buy the market in pieces using Select Sector SPDRs.   

Some people take issue with the fact that the multiple of the S&P 500 is stretched to insane levels at this late stage of a long-running bull market, and this isn’t a good time to buy. Mr. Buffett recommends index investing, but you will notice that Berkshire isn’t buying a lot of stock right now.  Mr. Buffett famously only buys cheap stocks.   An alternative to “buying the market” is to buy it a piece of the S&P 500 at a time.  

The S&P 500 is designed to reflect the overall strength of the US market.   For this reason, an attempt is made to try and include every kind of business imaginable.  Many of these businesses do similar things and make money in similar ways. There are a ton of different ways to break stocks down into categories, but the most common way of doing this for the S&P is to consider sectors.  There are many mutual funds and Exchange Traded Funds (ETFs) that let you buy an index of a particular sector.  

The overall S&P 500 Index may look calm, but there can be a lot of activity under the placid surface as traders rotate between sectors, trying to catch the next wave to the upside, or just trying to avoid the next correction to the downside.  These days, markets are moving toward a “defensive” posture and long out of favor sectors are making a resurgence.

The most common taxonomy is to break the market down into 11 major sectors.  At any given time, there will be sectors in the red and sectors in the green.  This happens on a day to day basis, and it happens on a much longer-term basis, consistent with the stage of the economic cycle.  A common way to track the performance of a particular sector is to watch price movements in the SPDR ETF (also known as “Spiders”) for each sector.  

Many traders know the tickers for each SPDR, and this allows them to assess what a particular sector is doing. You can do the same thing with simple free tools such as Yahoo! Finance.  Once you have registered with Yahoo!, you can go to the Finance section, and there are features that let you build custom portfolios.    Once in the portfolio section, you can simply click on Create Portfolio.  Give your new portfolio a name (e.g., “Sector Sort”) and start adding the SPDR tickets.  You can use the “Create New View” feature to provide some interesting information about each fund in your list.

Note that directly comparing sectors is an apples to oranges comparison.  Obviously, we can’t expect certain sectors to perform as well as others on average.   Perhaps the best way to judge the performance of a sector is to compare the current price with the highest price during a given timeframe.  This is what you’ll see in the table below. The “52-Wk High Chg %” column tells us how much the fund is now trading below its high for the last 52 week period.  We can see that the financials and consumer discretionary sectors are trading more than 10% below their 52-week highs, as are the industrials. I’ve also added index ETFs for the Dow Jones Industrial Average (DIA), the NASDAQ (QQQ) and the S&P 500 (SPY) for comparison purposes.  

Symbol Fund Name* 52-Wk High 52-Wk High Chg % 52-Wk Low 52-Wk Low Chg %
XLF Financial Select Sector SPDR ETF 30.33 -12.07% 23.79 12.11%
XLP Consumer Staples Sector SPDR ETF 58.95 -11.42% 48.76 7.10%
XLI Industrial Select Sector SPDR ETF 80.96 -10.87% 66.95 7.78%
XLB Materials Select Sector SPDR ETF 64.17 -8.91% 53.41 9.44%
IYT iShares Transportation Average ETF 206.73 -8.83% 162.38 16.07%
DIA SPDR Dow Jones Industrial ETF 265.93 -8.02% 212.68 15.01%
XLU Utilities Select Sector SPDR ETF 57.23 -7.09% 47.37 12.24%
XLV Health Care Select Sector SPDR ETF 91.79 -6.30% 77.82 10.52%
XLE Energy Select Sector SPDR ETF 79.42 -4.72% 61.8 22.44%
SPY SPDR S&P 500 ETF 286.63 -3.93% 240.85 14.33%
XLY Consumer Discret Sel Sect SPDR ETF 112.62 -2.06% 87.89 25.50%
XLK Technology Select Sector SPDR ETF 72.43 -1.89% 54.25 30.99%
QQQ Invesco QQQ Trust 177.98 -1.33% 137.5 27.72%
RWR SPDR Dow Jones REIT ETF 95.73 -0.46% 81.59 16.79%

*Note that there are mutual fund counterparts to all of these funds. 

The “52-Wk Low Chg %” column tells us how high the fund is now trading off if its 52-week low point.  Conventional wisdom tells us that the “out of favor” sectors are defensive sectors.  This means that these sectors tend to do well in bearish markets, but don’t have the explosive potential of other sectors in bullish markets.  Note that the REITs and technology have been flying, and they are near their highs for the past 52 weeks.

We shouldn’t take a single year perspective on long-term investment decisions, but on the face of it, it seems that the index investor would be better served by buying the “cheaper” financial and consumer staples sector right now and avoiding putting new money to work in the technology and consumer discretionary sectors. Also note that SPY (the S&P 500 ETF) is “high flying” as well, and it may not be a good idea to put new money to work directly in the index.

A more aggressive version of this strategy would be to set a cut point, say 25%, off the low for the year and rotate some of your portfolio allocation out of the most expensive sectors and into the worst performing.   In our current example, this would mean selling some XLK (Technology) and buying some XLP (consumer staples) with the proceeds. This is very similar to a portfolio reallocation strategy that most modern portfolio managers would suggest, except that my suggestion has more to do with how you put new money to work as opposed to how your existing capital should be allocated or reallocated.  

Note that there are also subsector funds, such that you can invest in an even more specific area of the economy.  If, for example, you think biotechnology has a brighter future than healthcare overall, then you can buy the IBB, which is a biotechnology fund.

These days, you can also do some very dangerous things with ETFs and even mutual funds by buying inverse funds and leveraged funds.  An inverse fund does the opposite of what the index it follows does.  If you buy an inverse S&P 500 fund, it will go up when the S&P 500 goes down, and vice versa.  This is particularly dangerous because US Markets have an upward bias, and over time, you will lose money.  If you believe that you can time markets, then buying such funds when there is “irrational exuberance” can be extremely profitable, and that is the allure.  

Leveraged funds use options contracts and other forms of financial wizardry to earn a multiple (such as 2 times) the return of the index. These are particularly dangerous because they are usually calculated on a daily basis, and volatility is doubled.  If you bet the wrong way, you can suffer massive losses in short order. When the biotech sector caught on fire Friday, July 6, 2018, the IBB returned a whopping +3.78%, while the leveraged ProFunds Biotechnology UltraSector Inv (BIPIX) returned +5.58%.  

If you are absolutely sure that trade wars will cause a recession and that the S&P is destined to crash, you can hedge your portfolio using an inverse leveraged fund such as the Rydex Inverse S&P 500 2x Strategy A (RYTMX).  Before you do so, I encourage you to pull up a 5 or ten-year chart and see just how abysmal the performance of that fund has been in a bull market. If you get the timing or the direction wrong, you can lose some real money really fast.  The most prudent course, then, may well be to rotate out of the high flyers into the defensive names that are already down and thus “selling cheap.” As Mr. Dalio says, the risk in holding the overall market is currently “asymmetrical”–there is much more room to the downside than the upside.