The trend is your friend until it punches you in the mouth

By David Nelson, CFA

“The trend is your friend until it punches you in the mouth” – Investor’s favorite pass time is extrapolating forward recent events into the future. If we’ve been headed higher over the last couple of months than by all means we should be on I-95 North for a few more exits. If a sector or group of stocks has dominated returns for an extended period, than it follows it will continue to lead.

A perfect example of this kind of mindset is the recent decision to revamp the industry and sector line up for the S&P 500. Friday was the re-balance which also coincided with a quadruple witch options expiration trading day.

The caretakers of the S&P 500 believe to stay relevant they needed to make changes to the index without changing any of the stocks. The creation of a new Communications Services sector was needed to better represent trends and give investors more access to growth.

Sector Relative Strength vs S&P 500 Quarter to Date
Sector w XLC rel to spx

However, if you’ve been doing this a while and a skeptic like yours truly you look a little deeper. While the change only took place Friday the SPDR Sector ETF (XLC) has been tracking the changes for a few months. Out of the gate the reviews aren’t great. Sitting in the toilet of relative performance (XLC) ranks last among the other sector ETFs quarter to date. It’s still early in the game but it begs the question is this alteration just a bit late?

Should of would of could of

Now if you had been invested in these stocks with the weightings suggested the returns are off the charts. Below is a comparison of cap-weighted returns for the sectors before and after the change. The new Communications sector would have given you a staggering 109% return over the last 5 years. I love betting on horses after they cross the finish line.

Cap-weighted Sector Returns Old Lineup
Cap weighted Ret old sectors

Cap-weighted New Sector Returns
cap weighted Ret new sectors

Make no mistake, it’s no small change. 10% of the S&P 500 market cap changes and the conservative Telecommunications Services Index disappears. 22% of the Consumer Discretionary along with 21% of Information Technology stocks move to the new Communications Services sector. In all some 26 stocks were re-classified including many tech favorites like Alphabet (GOOGL) and Facebook (FB) along with monster sized media companies including Walt Disney (DIS) and Comcast (CMCSA). Crossing the velvet rope to crash the party to mingle with the media elites are dividend heavy weights AT&T (T), Verizon (VZ) and CenturyLink (CTL).

According to a popular website for ETF investors, 241 ETFs have exposure to Facebook (FB) and 180 with exposure to Alphabet (GOOGL). It’s my guess that many of these same ETFs have exposure to both. I guess management at S&P Dow Jones Indices believe we can’t live without at least one more.

Stocks moving to Communications Services

26 companies make the move with Alphabet and Facebook dominating this new sector, two companies by the way that clearly have a target on their back. News that Alphabet employees actively discussed and explored ways to alter search results following the President’s travel ban broke last week while Facebook’s (FB) confession that they should have done more to protect their customers has dominated the news cycle for close to a year. Just 5 months ago founder and CEO Mark Zuckerberg testified before congress on previous data breaches along with failures to protect customer privacy.

The change in sector assignment is just the beginning. A drill down to the industry level unveils even more changes. At the top of the list is former tech stars moving from the Software & Services industry to Media & Entertainment. Media giants Disney (DIS) and Comcast (CMCSA) move from Media to Media & Entertainment. Really? Is renaming Media to Media and Entertainment really a value-added service?

Maybe the most bizarre is the industry change for Trip Advisor (TRIP) previously in the retailing industry. FactSet describes their business as an online travel company which owns and operates a portfolio of online travel brands so how is it that it’s necessary to now change its industry classification to you guessed it, Media and Entertainment.

Now we come to the real reason behind the change. In the end like most things in life it comes down to MONEY. Mutual funds and professional portfolio managers subscribe to many of these data services and use the historical classifications in back tests and advanced portfolio analytics software. Trust me it isn’t cheap and with a change this big you can bet many who don’t subscribe will be forced to do so. Not to mention the fact that the creation of new ETFs like the new Communications & Services ETF (XLC) is big money to providers as investors scramble to jump on board a train that left the station a long time ago.

*At the time of this article some funds managed by David Nelson were long CTL