Why Are Defensive Sectors Outperforming SPY?

The S&P 500 index, as measured by the SPDR S&P 500 ETF Trust (SPY), has underperformed traditional defensive sectors—utilities and consumer staples—over the past month. 

SPY’s one-month return is –0.3% while the Utilities Select Sector SPDR ETF (XLU) and the Consumer Staples Select Sector SPDR ETF (XLP) gained 7% and 3%, respectively. 

What does this say about investor sentiment? Is the economy beginning to soften? 

Technology, Consumer Discretionary Sectors Lag

Leading sectors in 2023—technology and consumer discretionary—are also beginning to stumble as they logged one-month declines of –0.4% and –1.5%, respectively, as measured by the Vanguard Information Technology ETF (VGT) and the Consumer Discretionary Select Sector SPDR ETF (XLY). 

The tech and consumer discretionary (also known as consumer cyclicals) sectors combine to make up 40% of the S&P 500 index. Furthermore, the so-called Magnificent 7 stocks, which have contributed more to the market’s returns than any other single group, come from these two sectors. 

Thus, the performance of the S&P 500 largely depends on the performance of the Mag 7 and the broader tech and consumer discretionary sectors. 

Why Are Defensive Sectors Outperforming SPY?

Over the past month, prices for utilities and consumer staples stocks have gained while technology and consumer discretionary stocks have dropped. This may signal that investors are rotating sectors or cutting exposure to risk areas while to defensive areas. 

Investors have had time to digest first quarter corporate earnings, which have been mostly positive according to Factset data. Still, sky-high expectations for Mag 7 stocks like Tesla Inc. and Amazon.com Inc. aren’t not being met, as reflected in their respective one-month returns of 1% and 1.5%. 

This week, other consumer discretionary companies like Uber Technologies Inc., Airbnb Inc. and Shopify, Inc. had positive earnings but provided weaker-than-expected forward guidance, disappointing investors and potentially indicating a softening in the economy.  

The recent shift in investor sentiment may be short-lived, but it’s possible that investors are beginning to anticipate a prolonged economic slowdown in the second half of 2024, which would favor defensive sectors like utilities and consumer staples over cyclical sectors like tech and consumer discretionary. 

SPY, Tech, Consumer Discretionary vs Defensive Sectors

Data as of May 8, 2024.

Key Takeaways on SPY vs Defensive Sectors

Note in the table that technology (VGT) and consumer discretionary stocks (XLY) produced strong returns in the past year, supporting the S&P 500 (SPY), whereas utilities (XLU) and consumer staples (XLP) lead in the past month, indicating a shift in investor sentiment and potential for sector rotation. Furthermore, nearly all of XLU's yearly gains are from the past month and XLP would be negative if not for last month's gains.

What Is Sector Rotation?

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

Different industries perform better at various stages of this economic cycle. For example, financials tend to do well during economic expansions, while consumer staples, also called consumer non-cyclicals, hold up better during recessions. 

Investors practicing sector rotation attempt to anticipate economic phases and shift their investments towards sectors poised to outperform in the coming period. By analyzing past economic cycles and the historical performance of different sectors during those cycles, investors may identify patterns. 

Bottom Line on Sector Rotation

Sector rotation can be a valuable tool for investors seeking to capitalize on cyclical trends in the market. However, its limitations as a leading indicator and the difficulty of precise market timing need to be considered.  

Trying to time the market perfectly (entering and exiting sectors at the exact best moments) is notoriously difficult and can lead to missed opportunities or poor decisions. Sector performance can be driven by factors beyond the economic cycle as industry-specific regulations, technological advancements, or global events can significantly impact a sector's performance. 

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

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