We’ve mentioned this story about sector weights before, but for the benefit of our newer subscribers we will briefly recap it:
When I (Nick) started covering the auto industry at the old First Boston Company in 1991, Fidelity was the US brokerage industry’s most important client. That meant every Wall Street analyst was in and out of their offices at least once a quarter visiting analysts and portfolio managers.
During one of those visits I wandered into the “chart room”, which looked exactly as the name implies. The walls were entirely covered with graphical representations of data, including everything from small cap stock charts to global GDP growth.
My Fidelity host pointed out one wall with a gaggle of PMs around it: the graphs showed the weighting of each sector in the S&P 500 and other equity indices going back over several decades. In pre-Internet times, this was not easy information to get.
The Fidelity PMs used this data to time sector rotations. For example, when Financials got to an “X” weighting in the S&P (say 6-8 pct), they bought the group and when it got to “Y” (10-12 pct) they sold it. They picked those ranges based on how the group had worked in the last cycle. Buy at the low end of the weightings band (when market sentiment on the group was bad), sell at the top (when it was high).
With that explanation in mind, here are the S&P 500 weightings for Technology (orange line, mostly at the top), Health Care (blue line, mostly in the middle), and Energy (gray line, bottom) from 2005 – present. Aside from 2018’s sector reshuffle, which took Google and Facebook (plus a few other names) out of Technology and into Communication Services, the data here is directly comparable across time.
Based on the analytical approach we outlined, we see three investable ideas in this graph:
#1: Overweight/Buy large cap Energy (XLE). This group’s weighting is now just 2.6 pct of the S&P 500. The floor was last October, at a 2.0 pct weighting. At the end of 2019, it was 4.4 percent. While this idea is not every investor’s cup of tea, we believe Energy should be able to get back to its pe-pandemic 4 percent weighting as global economies recover and commodity prices remain stable.
#2: Overweight/Buy large cap Health Care (XLV). At its current 13.4 percent S&P weighting, Health Care is actually a smaller part of the index than its 2015 – 2020 average of 14.4 percent. Given the manifold health challenges the US faces just now, that seems like a dramatic mispricing. Health Care was 15 percent of the S&P 500 as recently as Q4 2018.
#3: Maintain Tech exposure (XLK), even if it feels uncomfortable. Disregard that decline you see in the orange line around 2018; that’s Facebook and Google going to Comm Services. Note, however, that Tech’s peak S&P 500 weighting was in September 2020 at 28.2 pct. It is still not back to those levels (27.8 pct now), which says you’ve made a better return owning SPY or IVV than XLK over the last 10 months.
That short term observation aside, we do believe Tech is a core long-term holding even if that orange line would be at 35 percent (the topmost part of the graph) if you added GOOG/FB back to make today’s reading comparable to the rest of the time series. What other sector can truly compete with Tech’s ability to generate high returns on capital in a global and growing addressable market? None, in our view.
Closing out with a final observation: look at that chart one more time and you’ll see that Tech, Health Care and Energy all had a 14-15 pct S&P weighting in Q4 2008. Twelve years later and the story is very different; Tech took all of Energy’s weighting (and then some) by outperforming massively while Energy stocks wilted. Now, ask yourself where these lines will go in the next 1-5 years and allocate capital accordingly.