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.
||52-Wk High Chg %
||52-Wk Low Chg %
||Financial Select Sector SPDR ETF
||Consumer Staples Sector SPDR ETF
||Industrial Select Sector SPDR ETF
||Materials Select Sector SPDR ETF
||iShares Transportation Average ETF
||SPDR Dow Jones Industrial ETF
||Utilities Select Sector SPDR ETF
||Health Care Select Sector SPDR ETF
||Energy Select Sector SPDR ETF
||SPDR S&P 500 ETF
||Consumer Discret Sel Sect SPDR ETF
||Technology Select Sector SPDR ETF
||Invesco QQQ Trust
||SPDR Dow Jones REIT ETF
*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.