Since the birth of the New York Stock Exchange in 1792, the market has experienced an endless cycle of booms and busts. And despite the recent sell-off in the S&P 500, it appears the cycle is once again firmly in bullish territory. The clearest evidence of this comes as investors began selling consumer staples stocks in favor of cyclical stocks.
Consumer staples are popular investments in bear markets because they are considered inelastic to demand and offer investors’ portfolios a layer of protection from recessions. That’s been the case for much of 2022, as the S&P 500 Consumer Staples ranked third among all 11 sectors, thanks to steady gains from companies like Coca-Cola and J.M. Smucker. And for companies in that sector that posted losses in 2022 – such as Colgate-Palmolive, Costco and Target – they pale in comparison to the losses suffered by tech giants, including Alphabet (-35.2%), Amazon (-48 .3%), Tesla (-64.02%) and Meta (-64.4%).
However, as the market recovered in 2023, consumer staples posted the third-worst performance among all sectors. Then last March, with investors injecting nearly $100 billion into stock ETFs, the sectors driving these inflows included industrials, materials and energy – corners of the market typically lumped into the cyclical investing category.
Cyclical stocks include companies that are victims of all the booms and busts of the economy, doing very well when the economy is hot and poorly when it is not; let’s think of companies like Chipotle, LVMH Moët Hennessy Louis Vuitton or Disney as some examples. Meanwhile, the ETFs seeing the biggest outflows are healthcare and consumer staples, both of which are inherently defensive in nature.
The news is a perfect example of investors’ use of consumer staples and cyclical stocks. Many people have already invested in both types of stocks if they have a well-diversified portfolio. But whether investors hold more consumer staples or cyclical stocks is often determined by the state of the economy. Knowing how to leverage this knowledge can help protect portfolios when it’s needed most and help them grow when opportunities arise.
The pivot to cyclical stocks, even as interest rates remain high and inflation remains sticky, highlights bullish sentiment, as investors tend to take more risks when the economy is booming.
Here’s what you need to know about these two key asset classes and the possible direction of the market in the short to medium term.
Consumer staples securities
Regardless of what stage of the market cycle we are in or what shape the economy is in, investors typically have funds earmarked for consumer staples. These staples are, as far as consumer stocks go, some of the safest investments you can have.
The consumer staples sector includes companies that produce and retail products that are considered essential, that is, things that people will buy regardless of their economic situation. Think: needs rather than wants. Food and beverage stocks make up a large portion of consumer staples, as do companies that make drugs, hygiene products and household cleaning products. It also includes products that many would not consider staples, such as tobacco, alcohol, and even candy.
Although consumer staples are called big and boring, investors buy shares of these companies – especially during periods of stock market underperformance – because they are reliable. They don’t usually experience a sudden depreciation when the economy is bad because people can’t stop buying food or medicine, and many aren’t willing to give up things like cigarettes and alcohol even during a recession. In fact, consumer staples have outperformed the S&P 500 during all three recessions so far in the 21st century. Diversifying a portfolio with exposure to consumer staples provides investors with a certain stability that is not afforded by high-growth, high-volatility sectors like technology.
When it comes to appropriate portfolio weighting, however, consumer staples should not be the protagonist. Although they are averse to volatility, the gains you can expect from these stocks are quite limited, even in a healthy market. The S&P 500 Consumer Staples Index returns about 11% annually, compared to the broader S&P 500’s 14% annual return.
Recently, consumer staples have especially underperformed compared to other “safe” investments such as Treasury bills, certificates of deposit or bonds. In 2023, consumer staples took a hit as investors were more attracted to high-yield CDs and savings accounts, which offered guaranteed returns of 5% or more thanks to high interest rates as a result of the Federal Reserve monetary policy.
The central bank’s policy of raising interest rates was intended to tame inflation and lower the cost of basic consumer goods and other products, but inflation proved stickier than the Fed expected, the which hampered the performance of stocks in that sector.
Cyclical stocks
Consumer staples and cyclical stocks, which can also include stocks from the consumer discretionary sector, are two sides of the same coin. While consumer staples represent basic necessities, cyclical goods make up all the fun products and services that consumers might want, but don’t necessarily need.
The fluctuating demand for consumer discretionary goods can be exemplified by examining the industry’s performance during the 2022 bear market, and again by its performance in 2023 during the market recovery. In 2022, the Consumer Discretionary sector posted a loss of -37% and ranked second to last among the 11 sectors of the S&P 500. Last year, when the market entered bullish territory, it ranked third with a gain of +42.4%.
Examples of companies that offer exposure to cyclical stocks include clothing manufacturers, airlines, automakers, restaurants, and even appliance manufacturers. The common thread here is that people are willing to splurge on many of these products and services when the economy is good and they have extra money, but they are also the first thing consumers cut from their budget when they are financially limited.
It’s worth noting that cyclical stocks include many companies that sell products and services directly to the end user, but others are not as obvious as Starbucks, Ford, or United Airlines. Stocks in the energy and materials sectors, for example, are highly cyclical and tend to underperform when the economy is doing poorly and demand declines for things like building new infrastructure.
This is illustrated by the energy sector’s performance in 2020, when the COVID-19-induced recession led to a collapse in oil demand, which saw the sector finish last that year with a loss of -33.7%. However, in 2022, when the price of gas reached its all-time high and the stock market began to reverse, the energy sector recorded gains of +65.7%.
This has been the case again this year, with the energy sector recording a year-to-date gain of +13.4% compared to +4.2% for the consumer staples sector, with companies such as Devon Energy, Plains All American Pipeline and ExxonMobil which posted YTD gains of +13.7%, +17% and +17.8% respectively.
Which sector should investors target?
When the market is healthy, cyclical stocks tend to outperform consumer staples. The S&P 500 Consumer Discretionary Index sees an average annual return of almost 17%. Last year, that index returned more than 42% (third best among all sectors), while consumer staples limped to the finish line, gaining just half a point (third worst).
But beware, when times are tough, cyclical stocks perform exceptionally poorly, as demonstrated by the aforementioned 2022 performance of consumer discretionary goods. In a severe enough recession, companies operating in the cyclical space face greater risks of insolvency or bankruptcy than those in consumer staples. sector on which people continue to depend.
For investors seeking higher growth potential during bull markets, cyclical stocks may offer greater advantages. But for safety-minded investors, consumer staples continue to represent a safe haven. Ultimately, the decision on where to invest is determined by individual investor preferences, but diversifying with exposure to each of these sectors can offer the best of both worlds.
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