Diversification is one of the key building blocks of a successful investment strategy.

There are many types of diversification to help you minimize your investment risk. These include:

• Asset class diversification (equities, fixed income, real estate, commodities)
• Geographic diversification (domestic equities, international equities, emerging market equities)
• Company-specific diversification (Exxon Mobil (XOM), Chevron (CVX), Royal Dutch Shell (RDS-A, RDS-B)

The topic of this article is sector diversification. More specifically, this article will compare the performance of the different sectors of the S&P 500 over the past decade.

Interestingly, certain sectors of the stock market have delivered superior performance over long periods of time. Often, these sectors tend to be defensive and recession-resistant, so their outsized performance is accompanied by minimal additional risk. Accordingly, these sectors may merit an overweight allocation in your portfolio.

This article will provide data on the performance of different stock market sectors over time and perform an attribution analysis to see why certain areas of the market outperform.

Performance In Recent Years

Heatmaps are one of the most insightful visual representations of financial information.

The following diagram shows the annual performance of the 11 sectors of the stock market (as measured by the subindices of the S&P 500) over the past ten years.

Source: Novel Investor

There are multiple interesting observations that we can make from this data. Each will be discussed in its own section below.

The Best Performing Sectors Since 2007

There are four different S&P 500 subindices with double-digit total returns in the time period sampled (2007-1H2017). These subindices are:

• S&P 500 Consumer Discretionary Index
• S&P 500 Consumer Staples Index
• S&P 500 Health Care Index
• S&P 500 Information Technology Index

Why is this?

Each sector has its own unique fundamental characteristics that help to drive long-term shareholder returns.

Firstly, the consumer discretionary sector tends to outperform during bull markets as consumers allocate more disposable income to discretionary expenses.

When you think of consumer discretionary companies, think of ‘fun’ businesses. The four largest companies in the S&P 500 Consumer Discretionary Index right now are Amazon (AMZN), Comcast (CMCSA), Home Depot (HD), and The Walt Disney Company (DIS).

The performance of the S&P 500 Consumer Discretionary subindex is compared to the broader S&P 500 during the current bull market in the following chart.

Source: YCharts

Consumer discretionary stocks have outperformed the broader stock market in the current bull market as consumers have more money to allocate to nonobligatory purchases.

The Consumer Staples subindex has a different driver of total returns.

Notably, this sector generates persistently high returns on equity (ROEs). The ROE of the consumer staples sector is compared to the ROE of the consumer discretionary sector and the broader stock market in the following diagram.

Source: Investor Field Guide

What is truly surprising about the high ROEs of the consumer staples sector is its remarkable consistency to stay in that high-teens to low-twenties area.

One would expect that such attractive economics would invite ample competition, making business less profitable and driving ROEs downward. Clearly, this has not been the case, as ROEs have remained persistently high over long periods of time.

The third high-performing S&P 500 sector is healthcare, which is known for its recession resiliency.

Healthcare expenditures tend to be – and should be – one of the last expenditures to be cut when income is tight.

This translates to strong security-level performance for healthcare stocks during recessions. The performance of the SPDR Healthcare ETF is compared to the SPDR S&P 500 ETF during the last recession below.

Source: YCharts; note: ETFs were used because index data was unavailable for the time period. 

Healthcare stocks experienced much less of a drawdown during the 2008-2009 financial crisis than the broader stock market did. This is the primary driver of the sector’s long-term total returns.

The last sector – Information Technology – is a rather young sector, at least relative to the history of the domestic equity markets.

The strong performance of this sector over the last decade or so has been driven primarily by the fantastic performance of the mega-cap technology companies like Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Google/Alphabet (GOOG) (GOOGL), and Facebook (FB).

It is notably different from the other three best-performing sectors (consumer staples, consumer discretionary, and healthcare) because it’s strong performance has been driven primarily by innovation.

Also, the technology sector is characterized by a few big winners who deliver excess returns to compensate for the much higher number of stocks that eventually go bust.

This binary win/lose trait of the technology industry combined with the high levels of technical expertise required to understand the business of many tech startups makes it difficult to successfully pick technology securities outsized of the large- or mega-cap space.

The technology industry’s dependence on innovation also makes it highly prone to change.

Here’s what the world’s best investor has to say about change in the business world:

“We see change as the enemy of investments…so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.”

– Warren Buffett

Buffett runs Berkshire Hathaway’s investment portfolio and is the most iconic – and arguably the most successful – investor of our time.

When he makes bold statements like the one above, I tend to listen.

Altogether, the technology industry’s high level of necessary technical expertise combined with its binary win/lose track record and dependence on innovation make it – in our view – a less appealing sector than the other three outstanding sectors of the stock market: Consumer Staples, Consumer Discretionary, and Health Care.

The Worst Performing Sector Since 2007

Just as it is important to identify the best-performing sectors of the stock market, it can also be helpful to recognize which sectors tend to underperform.

This knowledge cannot help to pick which sectors to overweight.

It does exactly the opposite.

Knowing which sectors are chronic underperformers allows us to profit by omission by deploying our capital into more profitable endeavors.

The two worst performing stock market sectors over the past 10 years have been financials and energy, with annualized total returns of 0.85% for financials and 1.19% for energy.

This performance is very poor, but for each sector can be easily attributed to secular events that affected each industry as a whole.

For the financial sector, it was the global financial crisis of 2007-2009.

The impact of this event on financial stocks needs no introduction.

For a visual representation, consider the following diagram, which shows the cumulative total return of today’s 6 largest banks – JP Morgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), Goldman Sachs (GS), and Morgan Stanley (MS) – during the 2 years from January 1, 2007 to December 31, 2009.

Source: YCharts

For a more easy-to-digest visual, the following diagram compares the average price performance of these 6 financial institutions during the same time period.

Source: YCharts

Clearly, bank stocks took it on the chin during the last financial crisis.

Many of these institutions –  Citigroup comes to mind – have never recovered to their post-crisis levels.

This has seriously hindered the performance of the financial sector over the past 10 years. But, this does not mean that investors should avoid this sector completely going forward.

It is highly likely that the 2007-2009 financial crisis was a once-in-a-lifetime event. Moreover, today’s stricter lending standards and increased financial regulation lower the risk of poor performance from financial stocks moving forward.

All said, the next decade will likely be brighter for financial stocks than the last decade.

The other poor performing stock market sector over the past 10 years was energy, an industry that is heavily exposed to commodity prices.

Looking at the price of crude oil – the energy industry’s most important commodity – over the last 10 years can give some insight into why this sector has been the stock market’s second worst performer.

Source: YCharts

There have been two periods over the past decade that saw a sudden and substantial decline in the price of crude.

The first was during the financial crisis of 2008, when crude oil plunged from more than $140 per barrel to less than $40 per barrel, a decrease of more than 70%.

The second was in the oil per market that began in 2014, where oil prices dropped from more than $100 per barrel to less than $30 per barrel, another 70%+ decrease.

For clear reasons, this has been difficult for energy companies – particularly exploration & production companies – at a fundamental level.

It also meaningfully affects their security-level performance. The relationship between energy stocks and crude oil prices since the financial crisis can be seen in the following chart.

Source: YCharts

Visually, we can see that energy stocks tend to move in tandem with the price of crude oil (although there has been a spread between the cumulative total returns of the sector and the underlying commodity in recent years).

From a statistical perspective, energy stocks and crude oil prices have a correlation of about .6, with crude oil experiencing the higher level of volatility.

This can roughly be interpreted as follows: ‘for each 1% movement in the price of crude oil, there is a .6% movement in associated energy stocks on average‘. Clearly, this relationship does not always hold (in other words, divergence sometimes occurs), but this can help to give a sense of the relationship between the sector and the commodity.

So what does the future hold for energy stocks?

Like financials, we believe that the next decade will be much more favorable for energy stocks than the past decade has been. The sector is out of favor right now, providing opportunities for value investors.

It is very likely that oil prices will rise.

Mean reversion is one of the most powerful concepts in the financial markets.

With that in mind, consider the following:

• The average price of oil has been $71/barrel over the past 5 years
• The average price of oil has been $78/barrel over the past 10 years
• The current price of oil is ~$46/barrel

Mean reversion suggests that oil prices are likely to rise.

When they do, the long-term correlations between energy stocks and crude oil prices tell us that energy investors will be handsomely rewarded.

The Most Recession-Resistant Sector Since 2007

The decade following the year 2007 was a very interesting time to be an equity investor.

First, we saw the global financial crisis of 2007-2009, which cut the values of many investor’s portfolios in half and – as we saw in the last section – pummeled many financial stocks so hard that they have not returned to their pre-crisis price levels.

That cataclysmic period was following by one of modern history’s longest bull markets, which continues to this day.

Because of the longevity of the current equity run-up, many investors have postulated that the next bear market is coming around the corner.

While I can’t claim to know the exact timing of the next recession, one thing is certain – there is significant benefit to owning recession-resistant companies. Defensive businesses with strong competitive advantages and durable profit models will naturally deliver most of their outperformance when the rest of the market is falling.

With that in mind, it can be very helpful to look at the sectors of the stock market with the lowest one-year drawdown.

This sector is Consumer Staples, which had its worst year in 2008 with a drawdown of 15.4%. For context, the Financials sector declined by 55.3% during the same period.

The fundamental reasons why the Consumer Staples sector have outperformed during recessions is very straightforward. These companies produce ‘staples’ that are in demand through all economic environments.

Thus, revenues and earnings remain strong through recessions.

Recall that the Consumer Staples sector has also delivered the highest total returns over long periods of time. Accordingly, Consumer Staples stocks offer a compelling mix of high returns and low risk for long-term investors.

Final Thoughts

Analyzing the historical total returns of the different sectors of the stock market can be an insightful exercise for the individual investor.

There are two major trends that can be identified from looking at the data.

First, four sectors have delivered noticeably better performance than the broader stock market. These sectors are Consumer Discretionary, Consumer Staples, Health Care, and Technology.

While we tend to like the first 3 sectors over Technology, it’s likely that each of these sectors will continue to deliver strong total returns moving forward and may merit a prudent overweighting in an investor’s portfolio.

Second, two sectors – Financials and Energy – have lagged the market tremendously thanks to the financial crisis and the prevailing oil bear market. We believe that each of these sectors will deliver superior total returns in the coming 10 years compared to the past decade.