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Why are defense sectors outperforming SPY?

outperform - investment - comparison - chart

outperform – investment – comparison – chart

S&P 500 Index measured by SPDR S&P 500 ETF (SPY)has underperformed the traditional defensive sectors of utilities and consumer staples over the past month.

SPY’s monthly return is -0.3%, while Tools Select Sector SPDR ETF (XLU) and Consumer Staples Select Sector SPDR ETF (XLP) gained 7% and 3% respectively.

What does this say about investor sentiment? Is the economy starting to calm down?

Technology, consumer discretionary sectors Delay

The leading sectors in 2023 – technology and consumer goods – are also starting to stumble, reporting monthly declines of -0.4% and -1.5%, respectively, as measured by the index Vanguard Information Technology ETF (VGT) and Consumer Discretionary Selected Sector SPDR ETF (XLY).

The technology and consumer sectors (also known as consumer cyclicals) together make up 40% of the S&P 500. Moreover, these two sectors are home to the so-called Magnificent 7 stocks, which have contributed more to market gains than any other single group.

So the performance of the S&P 500 depends largely on the performance of Mag 7 and the broader technology and consumer goods sectors.

Why are defense sectors outperforming SPY?

Over the past month, prices for utilities and consumer staples have risen, while technology and consumer staples stocks have fallen. This may signal that investors are changing sectors or reducing exposure to risky areas in favor of defensive areas.

Investors had time to digest corporate earnings for the first quarter, which were mostly positive, according to Factset data. Still, sky-high expectations for Mag 7 stocks like Tesla Inc. and Amazon.com Inc., are not met, as reflected in their monthly returns of 1% and 1.5%.

This week, other discretionary stocks such as Uber Technologies Inc., Airbnb Inc. and Shopify, Inc., posted positive earnings but provided weaker-than-expected future outlooks, disappointing investors and potentially pointing to a weakening economy.

The recent shift in investor sentiment may be short-lived, but it is possible that investors are beginning to anticipate a prolonged economic slowdown in the second half of 2024 that favors defensive sectors such as utilities and consumer staples over cyclical sectors such as technology and consumer goods .

SPY, technology, consumer vs. defensive sectors

Data as of May 8, 2024.

Key takeaways on the espionage and defense sectors

Note from the table that technology stocks (VGT) and consumer discretionary stocks (XLY) have delivered strong gains over the past year, supporting the S&P 500 (SPY), while utilities (XLU) and basics have led the way last month consumer goods (XLP), as indicated by changing investor sentiment and the potential for sector rotation. Moreover, almost all of XLU’s annual gains come from the last month, and XLP would be negative if not for the last month’s gains.

What is sector rotation?

Sector rotation refers to the cyclical flow of investment capital between different sectors of the stock market as the economy and the stock market go through cycles, with periods of expansion, peak, contraction and trough.

Different industries perform better at different stages of the economic cycle. For example, the financial sector tends to do well during economic expansions, while consumer staples, also known as non-cyclical consumer goods, do better during recessions.

Investors using sector rotation try to anticipate economic phases and shift their investments towards sectors that are likely to perform better in the coming period. By analyzing past economic cycles and the historical performance of various sectors during these cycles, investors can identify patterns.

Conclusion on sector rotation

Sector rotation can be a valuable tool for investors looking to take advantage of cyclical market trends. However, it is important to take into account its limitations as a leading indicator and the difficulty in accurately timing the market.

Trying to time the market perfectly (entering and exiting sectors at exactly the best moments) is extremely difficult and can lead to missed opportunities or poor decisions. Sector performance may be influenced by factors beyond the economic cycle, as industry-specific regulations, technological advances or global events may significantly impact sector performance.

Some investment professionals view sector rotation more as a portfolio diversification strategy than as a strict market timing tool. By allocating capital across different sectors with different risk and reward profiles, investors can potentially improve the overall risk-adjusted return of their portfolio.

Investors should use sector rotation in conjunction with other investment strategies and conduct thorough research before making investment decisions.

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