Economic cycle
The economic cycle fluctuates over time, from peaks in expansion to troughs in recessions, and each phase affects the performance of index S&P 500 sectors differently. The S&P 500 index is considered one of the best overall indicators of the US stock market because it includes companies from all major sectors of the economy. These companies are selected based on their market capitalization, liquidity and sector classification. The economic cycle is constantly repeated and is divided into 4 phases:
- Recession
- Recovery
- Expansion
- Slowing down
The selected sectors have different levels of average performance, however, in any given period, certain sectors may outperform due to external factors such as technological advances or high-impact global events such as global pandemics, international conflicts and the like.
Methodology
The dataset is based on the Conference Board’s economic index, which measures economic activity in the US. This index includes 10 economic indicators that reveal typical turning points in the business cycle involving employment, consumer expectations and financial conditions. This methodology was developed on the basis of data from 1 December 1960 to 30 November 2019 and includes:
- 7 recessions
- 7 recoveries
- 12 expansions
- 11 deceleration
Returns are shown for all sectors of the S&P 500 except for the communications services sector. This is because the sector was created relatively recently in 2018 and includes earlier technologies, consumer products and telecommunications services that are already included in the data set.
Recession
Generally speaking, a recession is a period of temporary economic decline characterized by two consecutive quarters of decline in GDP. However, other important indicators are, in addition to the drop in GDP, an increased unemployment rate, a drop in consumption, a drop in consumer and business confidence indices, increased national debt and increased interest rates.
During that period, the best-performing sector in the S&P 500 index was consumer staples, and the only one that averaged a positive return. This was followed by the utilities and healthcare sectors, which are considered traditionally defensive sectors. Collectively, these sectors outperformed the overall market by an average of 10% during six of the seven recessions.
Real estate has performed the worst during the recession, given its high sensitivity to spending, as both household income and business activity tend to fall. On average, they fell by 22% during the recession. Big declines during this phase were also experienced by the technology sector, which fell by an average of 20%. Industry and the financial sector are quite similar during the recession, which tend to decrease by 15 and 13%, respectively.
Recovery
Recovery is the phase that follows a recession when economic activity begins to pick up and the economy begins to grow again. In addition to GDP growth, increased investment and other important indicators, this phase is characterized by a higher growth in real estate prices. This is the main reason why real estate has outperformed all other sectors with an average return of 39%. As monetary policy loosens after recessions and interest rates are historically low, buying real estate is more affordable, which in turn supports the sector’s performance. The same applies to the consumer sector, since there is more money in circulation, consumption automatically increases, with a historical average of 33%.
Based on historical data, we can observe that all the above-mentioned sectors are doing well in the recovery phase. All sectors posted double-digit gains as consumer confidence and labor market conditions improve during the recovery. In addition to real estate and consumption, the technology sector also grew significantly, by an average of 28%, and industry by an average of 27%. On the contrary, the public services sector, which historically shows an average return of 15%, is the least successful of the selected areas.
Expansion
In this phase of the business cycle, the economy is growing beyond recovery. It is characterized by increased economic production, employment and higher incomes. However, the main characteristic is that markets make new highs and continue to rise until the economy begins to overheat. Simply put, if GDP is still lower than before the recession, the economy is in a recovery phase. If GDP is higher than before the recession, the economy is expanding.
Interestingly, market returns were the second best overall just after the recovery phase. Top sectors included technology, which returned an average of 21%, financials, at 19%, and real estate, with an average return of 18%.
The utilities sector has historically seen the slowest growth of any sector, as investors tend to favor cyclical areas of the S&P 500 index that grow with an expanding economy. The health care sector also does the least, with an average return of 11%, but this area is one of the most balanced, as it grows approximately similarly in every phase of the economic cycle within the S&P 500 index, except for the recession.
Slowing down
This phase is often considered a peak or transition in the business cycle, when growth begins to decline, but the economy does not necessarily decline. It is mainly characterized by a slowdown in GDP growth, a decrease in investment, a decrease in consumption, an increase in unemployment, downsizing, inflation, changes in monetary policy and a decrease in stock prices.
With 15% average returns, the healthcare sector excelled during the slowdown phase. Investors often reduce their exposure to cyclical sectors as they prepare for an economic downturn and seek more defensive investments. Similarly, consumer staples have averaged strong performance, also with an average return of 15%.
Real estate, just like during the recession and in the slowdown phase, experienced a sharp decline. They have seen the lowest relative returns because the economy slows down and costs tend to rise. As a result of price increases, the consumer sector also grows the least, at an average of 6%.
The Case for S&P 500 Diversification
The data above shows how a diversified portfolio of investments can help reduce sector-specific risk given the different performance trends of individual sectors over the business cycle.