It's Time to Rethink a Tried-and-true Investing Pattern

One of the classic strategies in the stock market is to invest in cyclical sectors during economic booms and shift to defensive sectors during slowdowns. This idea seems simple, but the challenge comes in distinguishing between what counts as a cyclical sector and what is truly defensive. Recent market conditions, including the possibility of Federal Reserve rate cuts, the potential for growth without inflation, and expectations of Chinese stimulus, have triggered a rally in cyclical stocks. However, the broader picture remains unclear, with some metrics showing a strong cyclical uptrend, while others paint a more complicated scenario.

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One of the key complications in this market is the influence of technology stocks. Traditionally, utilities, consumer staples (such as food retailers), and healthcare companies are considered defensive sectors, known for their consistent sales even when the economy slows down. In contrast, consumer discretionary companies (like automakers), banks, industrials, materials, and technology were historically regarded as cyclical, meaning their performance tends to move with the broader economy. This divide worked well last Friday, when unexpectedly strong jobs data shattered the idea of a slowing economy. Financial stocks and consumer discretionary shares soared, while utilities dropped, and healthcare and consumer staples underperformed.

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However, the clear distinctions between cyclical and defensive sectors have been increasingly blurred. For years, the large, cash-rich technology companies have followed their own growth trajectory, often unaffected by economic downturns. The rise of artificial intelligence has propelled the "Magnificent Seven" tech giants—Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia, and Tesla—to dominate not just the technology sector but also consumer discretionary and communication services. This has complicated traditional classifications, as these tech giants influence multiple sectors, creating confusion in how to categorize them.

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Industrials, which were once a reliable gauge of economic cycles, no longer serve as a perfect proxy for the economy’s direction either. For instance, industrial stocks underperformed the broader S&P 500 last Friday. A strong economic outlook dashed hopes of a larger-than-expected interest rate cut from the Federal Reserve. Higher interest rates, in turn, hurt housing demand, making a housing boom less likely. As a result, six out of seven building-product companies within the S&P 500 industrials sector saw their stock prices decline, though gains in airline stocks and other groups helped offset some of the losses.

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A clear example of this problem, as well as a potential solution, can be found by looking at consumer-facing stocks. Typically, when the economy weakens and bond yields decline, the S&P 500’s consumer staples sector outperforms consumer discretionary stocks. This trend has been apparent this year, with consumer staples leading discretionary stocks, which would normally signal an economic slowdown. However, according to the Atlanta Federal Reserve’s GDPNow model, the economy actually grew faster than what the Federal Reserve considers sustainable in the third quarter. Meanwhile, the yield on 10-year U.S. Treasury bonds remains close to where it stood at the end of December, which contradicts the usual pattern seen in a weakening economy.

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A significant portion of the strength in consumer staples comes from its three largest companies: Walmart, Procter & Gamble, and Costco. All three of these companies have seen their stock prices rise sharply, reinforcing the notion that investors are seeking safety in defensive stocks amid growing concerns. On the surface, this supports the idea that investors are turning to defensives as a safeguard against potential economic instability.

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However, the consumer discretionary sector's underperformance is partly due to Tesla, the second-largest company in the sector behind Amazon, which has experienced a decline this year. Tesla’s struggles have dragged down the performance of the consumer discretionary sector as a whole, overshadowing stronger companies within the sector.

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To eliminate the distortion caused by individual companies dominating entire sectors, investors can use equal-weighted versions of sector indexes. These treat all companies in a sector equally, rather than giving more weight to the largest firms. When viewed through this lens, consumer discretionary stocks have actually outperformed consumer staples this year, which aligns more closely with the fact that the economy has been growing at a fast pace. This suggests that while the larger companies in each sector may distort overall sector performance, smaller companies in the consumer discretionary space have been benefiting from economic growth.

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In conclusion, the traditional approach of dividing stocks into cyclical and defensive categories has become more complicated in recent years, largely due to the influence of technology stocks and the dominance of certain large companies within each sector. While consumer staples are performing well due to the strength of a few key players like Walmart and Costco, the underlying dynamics show that smaller consumer discretionary companies are thriving in the current economic environment. The complexities of today’s market require a more nuanced understanding of sector performance, especially as the distinctions between cyclical and defensive stocks continue to blur.

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