Win, Lose, or Recover?

Friday, December 30, 2022

We finally made it to the end of 2022! Today marks the last day of trading for a very challenging year for equity and fixed income markets. Surging inflation, unprecedented global monetary policy tightening, China’s battle with COVID-19, rising recession fears, and the Russia-Ukraine war have been a few of the major headwinds. The arduous backdrop has underpinned a 19.2% loss for the S&P 500 as of December 29, likely making it the seventh-worst year for the index since 1928.

There have been very few winners as all but one S&P 500 sector is trading lower this year—energy stands out as the clear exception. The sector is coming into year-end with a return of nearly 60%, an impressive encore performance to its prior year return of 47.7%, making it the best-performing S&P 500 sector for back-to-back years.

On the losing side, communication services sticks out with a year-to-date loss of 40.4% as of December 29. Notable weakness among its larger-cap components have been a major drag on the sector this year. For historical context, the bar chart below breaks down the winning and losing S&P 500 sector performer for each year going back to 1990.

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The performance gap this year between energy and communication services is at 98.2%, making it the largest annual winner vs loser spread since the S&P GICS sector classifications began in 1990. Given the extremes, the next logical question to consider is what happens next—how do the top and bottom performing sectors perform over the following year and how much do their returns converge?

The chart below highlights the winner vs. loser sector spreads, including the spread between each sector over the following year. For example, the respective sector winner and loser for 2021 was energy (+47.7%) and utilities (+14.0%), and their 33.7% return spread last year is plotted along the bright blue line, while their spread in 2022 is plotted along the dark blue line. One of the primary takeaways from the chart is that the performance between the top and bottom sectors historically converges over the following year, evidenced by the drop in the average winner vs loser sector spread from 45.2% to only 3.3% over the following year.

This has at least been the case excluding the last few years. During 2019 and 2020, technology generated back-to-back winning years while energy posted back-to-back losing years. In 2021 and 2022, energy rebounded with back-to-back winning years and sizably outperformed utilities during both years. History suggests a three-peat for energy may be unlikely next year. Since 1990, no S&P 500 sector has made the winner’s circle three years in a row.

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The table below includes an additional breakdown of each year’s S&P 500 sector winner and loser along with spread analysis for each year. Sectors highlighted in green and red text depict back-to-back winning and losing years, respectively.

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A few observations:

  • Technology has the highest frequency among the winner’s list at 10.
  • Energy is the most prevalent on the loser’s list at six.
  • Last year’s winner outperforms last year’s loser 50% of the time. In addition, last year’s winner finishes higher over the following year 72% of the time, with an average return of 11.2%.
  • Last year’s loser outperforms last year’s winner 50% of the time. In addition, last year’s loser finishes higher over the following year 69% of the time, with an average return of 7.9%.

Given the variance in forward returns and historical convergence in spreads between the S&P 500 sector winners and losers, we created a hypothetical model to capture the potential reversion in returns each year. Simplistically, the model initiates a long position in the prior year’s losing sector and initiates a short position in the prior year’s winning sector. For example, this year the model would initiate a long position in communication services and a short position in energy. The chart below provides a breakdown of the model’s performance going back to 1990.

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Overall, the model generated an average annual price return of -3.3% since 1991, compared to the S&P 500’s price return of 9.5% during this timeframe, bringing the average relative performance to -12.8%. While the model finished higher each year 50% of the time, it only outperformed the S&P 500 41% of the time. The model also has a higher standard deviation of annual returns (28.0%) compared to the S&P 500 (17.4%).

In conclusion, variance in the top and bottom sector returns historically converge over the following calendar year. However, it is not a zero-sum game, as the best-performing sectors each year typically produce above-average returns over the following year. The worst-performing sector each year historically recovers with positive returns over the following year and relative outperformance over the S&P 500 occurring 53% of the time.



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