The Laggards of 2022 Became Leaders in 2023

Key Takeaways

• Performance last year was led by the laggards of 2022. A shift from defensive to offensive sector leadership could explain the worst-to-first narrative of 2023.
• Historically, the performance between the top and bottom sectors converges over the following year. However, convergence is often driven by a recovery in the prior-year’s underperforming sector and not necessarily by relative weakness from the prior-year’s sector winner.
• For example, the year’s best-performing sector typically does well over the following year, posting an average gain of 10.8%. This compares to an average next year gain of 9.3% for sector losers.
• Overbought conditions and profit-taking pressures after a nine-week winning streak for stocks have recently weighed on risk appetite. However, a few days of selling pressure do not make a trend, and LPL Research believes offensive sectors will reassert their leadership status once the pullback concludes.

The sharp rally in stocks last year caught a lot of investors off guard. A significant rotation in January from defensive to offensive sectors was considered by many as a relief rally off oversold conditions — few believed the strength was sustainable as recession headlines ran rampant. However, as it often does, the market proved the majority wrong, and the pain trade ran higher throughout the year.

With the narrative changing last year from a bear to a bull market, the script was also flipped in terms of leadership. As illustrated in the bar chart below, the bottom-performing quintile of S&P 500 stocks in 2022 delivered the best returns in 2023, while the top 20% of stocks in 2022 posted a gain of only 2.3% last year.

S&P 500 Return Comparison

The Worst of 2022 Move to First in 2023

Source: LPL Research, Bloomberg 01/04/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Of course, sector performance helps explain the worst-to-first theme of last year. Energy, an outlier during the bear market of 2022 (+59%), struggled last year amid concerns over global demand — notably China — and lower oil due to record-setting U.S. production. Utilities, another outperformer in 2022, lagged last year, losing 10.2% due to rising interest rates and the risk-on rotation.

In terms of winners, the large cap growth theme helped drive technology, communication services, and consumer discretionary higher. Technology, home to three Magnificent Seven stocks, was a standout after delivering a 56.4% gain, marking its best annual return since 2009.

The performance gap between technology and utilities last year was 66.2%, roughly double the average spread between the top and bottom-performing sectors based on S&P Global Industry Classification Standard (GICS) sector data going back to 1990. To assess the likelihood of a potential convergence in spreads, we analyzed how the top and bottom sectors performed over the following year. The chart below highlights the annual winner vs. loser sector spreads and the spread between each sector over the following year. One of the primary takeaways from the chart is that performance between the top and bottom sectors historically converges over the following year, evidenced by the drop in the average spread over the following year.

Annual Winner-Loser Sector Return Spreads (1990–2023)

Source: LPL Research, Bloomberg 01/04/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

The table below provides an additional breakdown of each year’s S&P 500 sector winner and loser, along with spread analysis for each year.

S&P 500 | Annual Sector Winners and Losers (1990–2023)

Source: LPL Research, Bloomberg 01/04/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

A Few Key Observations

• Technology has the highest frequency among the winner’s list at 11, meaning technology has been the top-performing sector nearly one-third of the time since 1990.
• Communication services, energy, and health care are the most prevalent on the loser list, tied up at six appearances each, implying that collectively, one of these sectors has been the worst-performing sector 53% of the time since 1990.
• Last year’s winner typically does well over the following year, posting an average gain of 10.8%. This compares to an average 9.3% next year return for sector losers.
• Last year’s winner outperforms last year’s loser 49% of the time. In addition, both last year’s winner and loser have finished higher over the following year 70% of the time.

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 a short position in the prior-year’s winning sector. For example, this year, the model would initiate a long position in utilities and a short position in technology. The chart below provides a breakdown of the model’s performance going back to 1991.

Long-Short Sector Convergence Model (1991–2023)

Source: LPL Research, Bloomberg 01/04/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Overall, the model generated an average annual price return of -1.5% since 1991, compared to the S&P 500’s price return of 9.9% during this time frame, bringing the average relative performance to -11.4%. While the model finished higher each year 52% of the time, including a 59.2% return in 2023, it only outperformed the S&P 500 43% of the time. The model also has a higher standard deviation of annual returns (29.7%) compared to the S&P 500 (17.3%). The data suggests that convergences between extreme sector performance each year may be appealing, but this trade has historically led to significant underperformance.

Summary

Stocks have stumbled out of the gate in 2024 as profit-taking pressures and overbought conditions from a nine-week winning streak weigh on near-term risk appetite. Technology, last year’s sector leader, is now underperforming, while defensive sectors such as health care and utilities are outperforming. However, a few days of price action do not make a trend, and LPL Research suspects offensive leadership will reassert itself once the current pullback concludes. History suggests technology could have another solid year, while utilities could play a little catch-up after notably underperforming in 2023.