The dramatic reversal in sector leadership within the S&P 500 Index during the past two years demonstrates the highly fickle nature of investors. It also illustrates how advisors can add value by encouraging clients to take a balanced approach to investing. In 2016, investors’ unquenchable desire for yield at time of historically low interest rates resulted in stocks with high dividend yields leading the S&P 500, which generated an 11.97% gain for the year. This was illustrated by Telecommunication Services and Utilities, which are characterized as having companies with high dividend yields, outperforming the overall market. Sectors such as Information Technology, Healthcare, and Consumer Discretionary, which consist primarily of companies with the potential for strong earnings growth, however, dramatically underperformed.
That trend continued into 2017, until rising interest rates and expectations of inflation resulted in a strong change in investor sentiment. Information Technology and Healthcare became the strongest performing sectors for the year. Consumer Discretionary also performed strongly, in part because the sector is expected to be one of the largest beneficiaries of tax reform, which has lowered corporate taxes.
As part of the rotation, Telecommunication Services performed the worst as investors no longer favored high-dividend-yielding companies. Other factors, such as price discounting, also weighed heavily upon the sector. Other sectors, such as Real Estate and Utilities, that high dividend yield constituents, also underperformed.
Investors who have remained committed to high-dividend yielding stocks have experienced no relief this year. According to Fidelity, the Telecommunications Sector dropped 8.69% during the first quarter compared to the 1.22% decline of the S&P 500. Utilities, Real Estate, Materials, and Consumer Staples were also among sectors that substantially underperformed the overall index. The positive returns of Consumer Discretionary and Information Technology, meanwhile, made those two sectors the best performers for the quarter.
For advisors, the dramatic variations in sector performance can be both a challenge and an opportunity. On one hand, clients may be frustrated if their portfolios aren’t strongly weighted in favor of sectors that are outperforming. Indeed, the fear of missing out on strong investment performance can be a powerful emotion that can result in clients questioning their advisors’ judgement.
On the other hand, advisors have a compelling opportunity to strengthen their relationships with clients. Advisors can provide value by encouraging clients to avoid taking big sector bets that can lead to substantial underperformance when market rotations occur. To that end, advisors should be prepared to provide financial models that can show the impact of being excessively overweighted in a small number of sectors.
Models should also illustrate how means regression can result in strong performing sectors eventually trailing the performance of the overall market. In other words, today’s hot performing sectors may end up eventually underperforming. With that in mind, maintaining a balanced approach to sector weighting--over the long term--may outperform strategies that tend to make big sector bets.
Advisors should also show how the higher levels of volatility that can result from taking sector bets may not be appropriate for investors who don’t have a long-time horizon.