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S & P 500 SECTOR CHANGES – WHAT THEY MEAN FOR INVESTORS

“From the Desk of Michael Sheldon, CIO”

The S & P 500 sector landscape is going to experience its biggest shakeup since 1999 when the Global Industry Classification Standard was developed by Standard & Poor’s (S & P). On September 28 (the last trading day of the third quarter), S & P, Dow Jones and MSCI will change their global classification system and recategorize certain stocks into new sectors of the market.  The new Communication Services sector will include the old Telecom sector, a few stocks from the current technology sector along with a number of holdings from the consumer discretionary sector.  Some of the biggest (most high profile) stocks changing sectors include names like Google, Netflix, Facebook and Disney.

The following changes (according to SPDR ETF’s) is forecast to take place:

  • 16 Consumer Discretionary stocks, representing 22% of the sector, will be reclassified as Communication Services.
  • 7 Information Technology stocks, representing 20% of the sector, will be reclassified as Communication Services.

The biggest change will be the reconstitution and renaming of the current Telecommunications sector (i.e. the telecom sector) to the new Communications Services sector. After the changes, the new Communications sector will represent about 10.6% of the S & P versus about 1.9% before the changes (more on this below).

A Look at Sector Changes

With a number of high-profile stocks within the S & P 500 Index being reclassified, sector weights post the upcoming changes will look a bit different than they do now in some cases. Below is a table depicting the percentage change for each of the three sectors experiencing changes.  For example, the prior telecom sector will grow from 1.9% of the market cap of the S & P 500 to 10.6% (a large change), the consumer discretionary sector will decline from a 12.8% weight to 10.1% weight (a modest change) while the technology sector will decline from 26.5% to 20.5% of the S & P 500  (a moderate change) – see chart below (source: Strategas Research).

Following the changes highlighted above, the technology sector will remain the largest weight in the S & P 500, but its influence will be reduced somewhat.  It’s hard to really tell but that could be one of the goals of the changes S & P is making.  The chart below (source: Strategas Research) highlights what the sector weights of all 11 sectors in the S & P 500 will look like following upcoming changes.

The top three sectors will be technology 20.5%, healthcare 14.2% and financials 14.1% and the bottom three sectors will be materials 2.5%, REIT’s 2.7% and utilities 2.9%.

For investors, it’s important to dig beneath the surface to understand how the various characteristics of the telecom, consumer discretionary, and technology sectors are likely to change going forward.  For example, the new communication services sector will have a much lower dividend yield (1.5% versus 5.2%) and higher trailing price to earnings ratio (17.2x versus 12.8x).  As a result of the various stock changes taking place, the revised communications sector is likely to be much more growth oriented with a higher beta (note: S & P forecasts that the sectors beta i.e. level of volatility versus the overall market is likely to rise by two thirds from 0.6x to 1.0x after the changes).  Importantly, the new communications sector is not going to provide the same level of safety and yield that the old telecom sector did in the past.

The yield for the consumer discretionary sector is forecast to stay the same (1.1%) while the price to earnings ratio will rise slightly from 22.5x to 23.5x.  In terms of the technology sector, the dividend yield will rise slightly from 1.1% to 1.3% and the price to earnings ratio is forecast to rise slightly from 20.0x to 20.4x.

Following the reclassification, the broad market will become less concentrated because technology will have a lower overall weight (declining from about 26% to 20% of the S & P 500).  However, if you look at each sector’s top five holdings, the technology and consumer discretionary sectors will actually end up more concentrated (see chart below – source: Factset / Goldman Sachs Global Investment Research).  Looking at specific companies, as an example, Amazon will now be 30% of the consumer discretionary sector (up from 23%) while Apple will now be 19% of the technology sector (up from 15%).

One question is how mutual fund managers may adapt to the new sector changes.  That is a challenging question to answer but we can give it a try.  First, according to Morningstar, there is currently $73 billion in mutual fund assets invested in global “technology” mutual funds (source: Goldman Sachs Global Investment Research). While the new sector changes will change how stocks are labeled in terms of sectors (for example Google will now be communication services versus technology and Netflix will now be communications services versus consumer discretionary), fund managers are unlikely to sell stocks just because they now belong to a different sector.  Ultimately, it’s the growth characteristics and business fundamentals of a company that lead a fund manager to either buy or sell a specific stock.  Therefore, we don’t think the sector changes that are taking place are likely to cause large amounts of buying and selling by mutual fund managers.

Below we have provided a chart of what the new communication services sector will look like (source: Goldman Sachs Global Investment Research).  As a reminder the old telecom sector just had three telecom companies, AT &T, Verizon and Century Tel. The new communication services sector has a mix of social media, content, old line telecommunication providers, as well as gaming and cable companies.  This will certainly be a big change from what investors were used to in the past.

As always, we welcome any comments you may have.

Respectfully,

Michael Sheldon

Sources:

Goldman Sachs Global Investment Research

SPDR ETF’s

Strategas Research

S & P

Disclaimer:

S & P 500 – The S&P 500 Index is widely followed gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

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