The turnaround in sector leadership from 2013 to 2014 has been an interesting changing of the guard. Last year, consumer discretionary stocks were high fliers as companies like Amazon (AMZN) and Priceline Group Inc (PCLN) emerged as momentum favorites. By contrast, 2014 has been a year of investors exchanging their growth stocks for stalwart value companies with strong yields such as Duke Energy Corp (DUK) and Southern Company (SO).
The Consumer Discretionary Select Sector SPDR (XLY) was the strongest S&P sector group of 2013 with a gain of 45.59%. However, this year XLY has slipped to the bottom of the rankings by posting a meager return of just 3.63%.
On the flip side, the Utility Select Sector SPDR (XLU) was the weakest sector of 2013 with a relatively tepid gain of 14.61%. This year, it is leading its peers with a jump of 15.92%.
Consumer discretionary stocks are often considered economically sensitive investments because their revenue growth is derived from a confident and free-spending consumer. Many of the underlying holdings in XLY are made up of retail, media, travel, automotive, and luxury goods manufacturers.
Conversely, utilities have long been considered a defensive corner of the market because of their non-cyclical demand and consistent cash flow. Money flowing from one sector to the other may indicate a significant change in risk behavior fueled by concern over a market correction or predictions of additional volatility on the horizon.
One important driver of this structural shift in 2014 has been falling interest rates and moderate inflationary statistics, which are considered a beneficial environment for utility stocks. These companies normally have an inverse relationship with interest rate moves (similar to bonds) because of their high dividend yields and reliance on financing to support their operations. The CBOE 10-Year Treasury Note Yield has fallen more than 22% this year amid strong demand for safe haven assets.
With so many dynamics in play, the perfect switch from leader to laggard and vice versa is an interesting wrinkle in the market narrative. Sector rotation and value-focused investors won’t likely take it as any surprise considering the historical precedent of money seeking out more opportunistic investment themes. As valuations get stretched, specific areas of the market become less attractive and may invite competition from overlooked sectors that are trading below the market average. Even with the recent underperformance, XLY still has a price/earnings ratio of 18.91 compared to 16.41 for XLU.
Not surprisingly, ETF fund flow data supports this shift as well. Through the first eight months of 2014, XLU has seen net inflows of $814 million, while XLY has had outflows of $1.08 billion. This represents money chasing relative performance and moving out of stocks that are not making positive headway this year.
From a strictly observational standpoint, investors can learn a key lesson from this rotation. Be wary about continually chasing the performance leader each year because by the time you identify the best, the move has likely already been made. As a result, last years sector leader can easily fall to the bottom of the pack in performance the following year and vice versa.
This performance chasing anxiety is one reason why many investors have opted to build out the majority of their portfolio with core holdings that represent a diversified mix of sector and industry groups. In addition, further diversification in international markets, commodities, or alternative themes have shown to lower volatility and increase the likelihood more consistent long-term results. While a focus on specific sectors can add a measure of alpha under favorable circumstances, a successful outcome will require staying ahead of the curve to avoid being lured into overvalued areas of the market.