Equities: Will Last Year's Near Perfect Sector Rotation Continue in 2023?

Equity markets reversed direction in two distinct ways in 2022.  First, and most obviously, major indices such as the S&P 500®, Russell 2000, Dow and Nasdaq 100 fell after rising sharply in 2020 and 2021.  Secondly, and not as apparent, was a near perfect sector performance reversal.  The sectors that had performed well in 2020 and 2021 declined, whereas sectors that had performed poorly in 2020 and 2021 generally rebounded (Figure 1).

Figure 1: 2020-21 versus 2022 sector returns correlate at -0.81

There are 17 U.S. equity sectors on which there are listed futures contracts.  These 17 sectors 2020-21 versus 2022 total returns yields a correlation coefficient of -0.81.  The most striking reversals came in six sectors:

• The PHLX Semiconductor Sector Index returned +121% over 2020 and 2021, and -34% in 2022
• The S&P 500 Select Information Technology Index returned +90% over the course of 2020 and 2021, only to lose 34% in 2022.
• The S&P Select Retail Industry Index returned +44% over 2020 and 2021, and -25% in 2022
• The S&P 500 Select Consumer Discretionary Index, which includes automakers, airlines and luxury goods makers, returned +63% over 2020-21, and -38% in 2022.
• The S&P 500 Select Energy Index lost 8% over the course of 2020 & 2021, and returned +59% in 2022.
• The S&P Oil & Gas Exploration & Production Select Industry Index returned 8% over 2020-21, positive but far below the S&P 500’s overall return of 53% over the same period.  In 2022, the index returned 44% to investors even as the S&P 500 returned -18.5%.  

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In 2022, many of the assumptions of the previous two years were upended.  As pandemic restrictions eased and the world reopened, travel resumed to the benefit of the energy sector.  Energy prices also rose as Russia’s invasion of Ukraine severely disrupted the supply of oil and gas between Russia and its European neighbours.  Higher energy prices helped to boost the shares of oil & gas services companies in particular, many of which had suffered early on in the pandemic. 

By contrast, in the early stages of the pandemic, investors poured money into technology and consumer discretionary stocks as the world became more online focused and as government stimulus programs bolstered consumer spending in discretionary manufactured items.  The Federal Reserve’s $4.9 trillion quantitative easing (QE) program, along with similar balance sheet expansion by the Bank of Japan, European Central Bank and Band of England, also fuelled a speculative rally in these shares as investors chased returns, sometimes for fear of being left out.  In 2022, amid rising inflation, governments ended stimulus programs, central banks began raising rates and reversing their QE policies.  As such, money started to leave these highly valued parts of the equity market in search of better valuations elsewhere.

But what does history tell us about the possible sector outcomes for the rest of the decade?  The original 10 S&P Select Sector Indices (with data going back to 1989) might give us some insight.  In many ways 2020 and 2021 were a continuation of the 2010s from a sector performance perspective.  The same sectors that prospered in the 2010s, including IT, healthcare and consumer discretionary stocks, continued to do well, while energy stocks remained underperformers (Figure 2).  

Figure 2: 2020 and 2021 looked a lot like the 2010s in terms of sector performance

The 2010s, however, looked very different than the 2000s, when IT, consumer discretionary, financial, and telecom stocks suffered while energy, materials, and consumer staples stocks outperformed (Figure 3).  The 2000s were in turn a sharp reversal from the 1990s, which closely resemble the 2010s with IT, consumer discretionary, and health stocks dominating while energy, and materials stocks suffered (Figure 4).

Figure 3: Sectors that underperformed in the 2000s tended to do well in 2010s and vice versa

Figure 4: The 2000s turned the sector trends from the 1990s on their heads

This leads to the question: Was 2022 a flash in the pan or the beginning of a longer-term reversal in the fortunes of the various equity sectors?  While nobody can know for certain, the history of the past few decades points to the possibility of a longer-term reversal in relative performance of the various equity sectors.  If the 2000s reversed the sector trends of the 1990s, and the period from 2010-2021 reversed those of the 2000s, it is plausible that the remainder of the 2020s might look more like 2022 than  the tech-dominated 2010s.  That said, the ultimate outcome for the various sectors will depend on many factors, including inflation, short-term interest rates, long-term bond yields, the energy transition and the strength of consumer spending in the face of rising living costs.

In particular, the valuations of IT stocks, which constitute roughly one quarter of the S&P 500 and half of the Nasdaq 100 market cap, depend on inflation and long-term bond yields being contained.  It may be reasonable for these firms to have high valuation ratios when long-term bond yields are extremely low as they were in 2020 and 2021.  Low long-term bond yields raise the net present value of these firms’ anticipated long-term cash flows.  However, higher bond yields threaten these valuations.  As such, a return to lower inflation and lower long-term bond yields might be necessary to get IT stocks to rally once again.

Meanwhile, with inflation squeezing consumer budgets, real estate prices beginning to fall in much of the world coupled with higher consumer borrowing costs and the end of COVID-related stimulus, its not clear that consumers will have the budget to fuel growth in discretionary purchases in the years ahead.  Consumer discretionary shares are especially vulnerable to the possibility of a recession in any of the world’s major economies, which remains a possibility given the sharp tightening of fiscal and monetary policy as well as disrupted flows of oil and gas stemming from the Russo-Ukrainian War. 

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