Financial Categories & Sectors Explained

Financial categories and sectors are commonly referenced in market commentary. For example, you may have heard the terms consumer staples or industrials. However, there are several others and it is important to understand what they are when reading financial commentary or doing investment research.

Summary – Cents of Security Podcasts Ep. 60

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I'm Cassidy Clement, Senior Manager of SEO and Content here at Interactive Brokers.  

And today I'm the host for your podcast. And our guest is Caleb Silver. He's the Editor in Chief of Investopedia and the host. 

Today, we're going to be talking about financial categories and sectors. They're commonly referenced within financial commentary and different types of financial literature. For example, you may have heard the term of consumer staples, industrials, or utilities. And there are several others to that list, though, and it's important to understand what they are when you're reading commentary or if you're doing certain types of investment research. So welcome back to the program, Caleb. 

Caleb Silver 

Good to be with you. 

Cassidy Clement 

Both yourself, myself, with the line of work that we do, we hear different financial categories and sectors being thrown around all the time, whether we're talking about headlines or even if we're just talking about sector investing, right? 

So what exactly are the financial categories or sectors that investors would be familiar with and what exactly makes up each of those categories? 

I know in my research, I think there's a mix between, depending on who you're talking to, maybe eight, maybe ten, eleven. It can vary, but what are those main ones? 

Caleb Silver 

Yeah, actually in the S&P, the Standard Poor's, there's twelve super sectors. Those super sectors are ones you might be very familiar with, like technology, right? There's also internet and communications. That's your Alphabets of the world, your Metas of the world. There's staples, and staples could be those “staple-type” businesses that we shop at no matter what economic conditions we're facing. 

That would be a Unilever. That could be a Costco, it could be a Staples store itself that sells office supplies.  

Then there's discretionary. S&P Discretionary, and that could be anything from a Tesla, which is a discretionary purchase, even though it's an automaker. Even an Amazon is sometimes considered discretionary as well. 

So up and down, the S&P, there are those twelve super sectors. Of course, there's energy. And in energy, you're going to find oil and gas stocks and other types of stocks in the energy sector. So there's twelve of them to get familiar with. We are much more familiar with big stocks like an Apple or an Amazon, but rarely do investors think about sectors. 

As you evolve in your investing education, you start to think a little bit more closely about that because you find if you watch the market closely enough, there is a relationship between the performance of sectors, depending on what's going on in the market and the economy. 

Cassidy Clement 

So, expanding on some of those other ones, like mainly the materials or the financials, utilities, et cetera, some of them have a label of cyclical and some have non-cyclical labels. 

What exactly does that mean and how does it apply to the different categories? Does the definition stay the same for them or does it vary based on, like I said, maybe it's utilities, maybe it's staples? 

Caleb Silver 

Yeah. Great question. You hear about cyclicality in the markets and in the economy. And it is very true when you're looking at sectors when we're talking about cycles, we're typically talking about economic cycles, but you could also be talking about a market cycle. Let's stick to the economy for right now. 

A cyclical sector could be something like discretionary, consumer discretionary, right? If we are feeling that we're tight on money and consumers want to spend less and start to rein in their spending, you're going to feel that cyclical sector have an impact. We're going to spend less on discretionary things like travel, like going to Disney, to the Magic Kingdom, Like potentially making our purchase of a Tesla vehicle, right? 

That sector might contract during a slowdown in the economic cycle if you have other cyclical sectors like a utilities sector. Usually when you hear about an economic slowdown or a potential recession, or there's trouble in the tech part of the stock market, the fast-growing part, utilities perform well. 

Why? Because they have recurring revenue and they pay big dividends. We don't shut off our power, we don't shut off our lights when the economy goes bad if we can help it. That's the last thing we do so utilities fare better in downturns and economic cycles that are facing downturns. 

So that's why cycles are important, both in the market and in the economy, and then intrasector cycles are very important.  

So while discretionary might be suffering because of a consumer pullback, staples might rise. And as an investor, you want to think about where you want to position yourself for these different cycles. 

Cassidy Clement 

So the non-cyclical items, are those also, the labels, we'll say, they also apply to certain types of stocks in a general sense? 

Like what would it mean when we say, oh, this stock is part of this sector and it's cyclical. This stock is part of another sector and it's non-cyclical. 

Caleb Silver 

Yeah, great question. So, some cycles last a year or two, some cycles last eras and really represent a shift in a technological dynamic. So think about a company like NVIDIA or a chip maker that's making semiconductors. Even Intel is in that category. Well, that's not cyclical. We're going to be using chips for a long time. 

So it's in a super cycle. The semiconductor industry is in a super cycle where we're just going to need more and more semiconductors as far out as the eye can see. 

Some people call semiconductors the railroads of the 21st century. We can't do anything without them. You and I can't have this conversation without a lot of semiconductors firing off different processes through our computers that we're able to have this communication and then put it out for people to listen to. 

So that is non-cyclical because it is a part of a broader super cycle. That's very different than saying, Oh, we're facing an economic downturn potentially in the next six to twelve months. Well, we know chip demand might be affected, but we also know chip demand is on this broader curve that goes out decades. 

Cassidy Clement 

So, in this example, we're talking about like NVIDIA and semiconductors. It's a very popular topic, but of course, most people can incline based on what we're saying, we're talking about technology and a very large industry at one for this time in the Earth's timeline here. 

But what are some ways or some common examples of ways that people invest in these sectors that we're talking about? 

Because sector investing is a thing. I think technology is probably the easiest example to give, what are some ways that people do it? You hear sector investing floating around, especially when Cycles come into play. 

Caleb Silver 

Sure. You can express that investment through individual stocks. So I mentioned utilities, right? If you're fearing an economic downturn, if you feel like a recession might be coming, if you feel like tech stocks are overheated, you can express that through buying utilities. And the utilities are the biggest power companies in the country. 

And you can buy those individually or you can buy an exchange traded fund that holds the biggest utilities in it. There are plenty of those out there available for investors to purchase. There's ETFs for basically every which way you want to express yourself in the capital markets today. So you could buy an entire basket of utility stocks through an ETF or an index fund. 

There are some mutual funds that concentrate on sectors as well. They are less popular. The biggest mutual funds really concentrate on the overall market.  

So, again, the individual companies or an exchange traded fund or an index fund that focuses very specifically on the sector, and you will know them when you see them. 

You could search for them and find ten ETFs that will give you access to the utility sector if you want it. Or if you just wanted solar, you could buy an ETF, an exchange traded fund, that has twelve to twenty solar stocks in it, too. 

Cassidy Clement 

So you're able to find investment options that are concentrated in these sectors and you don't necessarily have to go out then and make a portfolio yourself. They're already out there for you to page through them. You could look through what makes up these funds, but is that kind of the most popular way that people do sector investing is they look to already established funds? Or is it an even split where people start to make their own portfolio for a sector investment strategy? 

Caleb Silver 

Yeah. It depends on how you like it. I personally prefer exchange traded funds because I'm a terrible stock picker and if I think I'm picking the right one I've definitely picked the wrong one. I'm a good contrarian.  

If I'm picking something you should buy the other way. I learned that I'm better at buying ETFs- exchange traded funds that cover a sector. 

Now the thing about buying exchange traded funds is there's a couple of things you want to look for. You want to look for big ones, right? The bigger the better because there's a lot of liquidity in those exchange traded funds. There's a lot of investors that are in there already and they're sizable. That means that big shifts in that market or in that sector are not going to affect it as much as if it was an individual stock.  

Let's take a recent example, CrowdStrike. Okay, right, a cyber security company with some of the biggest customers around the world, including airlines, including the government, right? 

When CrowdStrike had a problem with updating its software, it basically shut down anybody that was running the Microsoft operating system, which included airlines, which is why we had so many delays a couple of weeks ago. Well, that stock took a huge hit that day, over 30%. One stock fell 30%. 

The entire basket of cybersecurity stocks didn't fall at all. In fact, several of the other stocks rose because CrowdStrike was falling. That's a great way to diversify. Give yourself exposure to a sector without actually picking one company to do it. That's my preference. There are other people that are much more into buying individual companies and building their portfolio. 

Like it was a chessboard of here's my defensive stocks. There are six of them. Here's my offensive high growth stocks or six of those here are my staples no matter what and I love bank stocks All I just buy a bunch of bank stocks. So there's different ways to approach it. It is Burger King have it your way and today in today's capital market You can have it any which way you want. 

Cassidy Clement 

That's the perfect segue into my next question because normally, you go out into the market, you pick and choose what you want, and you can make your own portfolio. Like you said, it's a chessboard. I think that's a really good way to put it.  

Or you can kind of look to products that are already set up that way so that there's a little bit more of a large amount of liquidity or something like that. 

There's a little bit more flexibility within those products. But when we're talking about sector investing in general, or sector investing strategies, what are some things that investors should keep in mind to even go down that road, or what are some questions that they should ask themselves if they're thinking, I might want to plan for this? 

Caleb Silver 

One of the six golden rules of investing is know what you own and know why you own it. So it's one thing to say I feel like semiconductors are going to be here for the next ten to twenty years. And I want to be invested in that sector. I'm looking at a long-term cyclical trend and I want exposure to an industry that I think is right at the heart of it, right? 

That's one way of expressing yourself. But if you're just picking willy nilly and not thinking about your strategy or where we are in a broader cycle, then you're just really throwing darts at a board without looking at that dartboard.  

You want to know and have a very specific idea of why you're investing in certain sectors or in certain companies. 

That may be because they're well positioned, depending on where we are from a cyclical perspective, but it may also be because you feel like something will develop over time. And here's another example.  

“I feel like water is going to become more and more scarce around the planet.” That's just me reading a lot and figuring out that we're going to have issues. 

It's raining a lot here today, but droughts are a very serious issue and it's only going to get, I think, more intense as climate change becomes an even bigger part of our daily reality.  

So, you can buy water companies through exchange traded funds. Is that a cyclical sector or is that just a trend that is happening on the planet as it warms up? 

I believe that's a longer trend, so I want exposure in that case to that sector. I have a reason, based on research and evidence, that makes me want to own companies that own private water resources. That is me expressing my investing interest through what I think is going to happen on the planet, and I can actually buy stocks or buy exchange traded funds that represent that. 

So you want to know why you're doing it. And the reason can't be because that influencer over here told me to do it or my friends doing it. It's got to be very personal to you. We call it personal finance and wealth building for a reason. It's personal to you and it's personal for me. So, and I'm 53. 

My investment choices, my sectors that I choose to invest in, the way I express myself as an investor should be very different for you, who's much younger than me. 

Cassidy Clement 

Well, when you were talking a little bit about the water trend, we'll say, as an example, when people start to look into sector investing, kind of to go back to my previous question, is there a certain type of caveat that goes with selections that are cyclical versus non-cyclical?  

Is that something where you would say, okay, well, this is actually going to be something I got to sit on for a little bit because it's going to be long term or this is something that I really need to keep up on my research for this trend because it may actually be shorter of a time horizon on my investment than I anticipate? 

Caleb Silver 

Yeah. Great question. And we have this thing in investing called sector rotation. It is actually the lifeblood of the market. So if anybody's been paying attention to the U S stock market over the past couple of months, we have gone, we have had a sector rotation from mega cap technology stocks, chip stocks, and AI stocks, which were the favorite for most investors for about a year and a half here, and they have, they were basically carrying the stock market. 

We've rotated sectors, right, to more value stocks, financials, healthcare, smaller stocks that will do better as interest rates come down. Now that is definitely a cyclical thing. Interest rates have been at a multi-decade high now since last year, the Fed raised rates for the last time about a year plus ago. 

They've been at this 5.25 to 5.5%, and the Fed has basically told us they will be lowering interest rates maybe as soon as this September. And if you look at the Fed's dot plot, and not everybody has to do this, just econ geeks like me, we look at the summary of projections for where the Fed thinks interest rates should be, and they're going to be lower next year, and they're going to be even lower the year after, according to the Fed's projections. 

Knowing that interest rates are coming down, you want to sector rotate into those sectors that will do better as rates fall. And those typically are financials. Banks will loan more money in a lower interest rate environment because it's cheaper to borrow money. Healthcare companies carry a lot of debt. 

They will do better in that type of environment. They also do better in slowing economies because we don't stop spending on our healthcare. We also know that small stocks like those stocks in the Russell 2000, stocks between $2 billion and $10 billion will do better in a lower interest rate environment. 

Why?  

Smaller companies carry more debt. If debt gets cheaper because rates are coming down, their balance sheets are going to look a lot healthier. Classic example of sector rotation based on a cyclical event in the economy, and that's why you want to pay attention to it. Interest rates are a great flag for things are going to change because the rates are going to change. 

I should make sure I am prepared for that as an investor. 

Cassidy Clement 

So this one's just an extra question because we're talking about sector rotation and a little bit about the Fed.  

When it comes to times like these where we've seen the big word floating around is inflation, right, how does that change the outlook on these major sectors in the market? 

You were talking about how it leads to potentially lower interest rates, maybe more value stocks. When it comes to things involving inflation, is there anything historical that tends to show true? Like the staples are going to be, what's good while inflation is high versus discretionary while inflation is going down? 

Caleb Silver 

Yeah, great question. Inflation just means a rise in prices. So what companies have pricing power as prices rise where they're able to raise their prices and customers will not turn their back on them? You think about things like streaming subscriptions, right? We just heard that Disney raised the price of Disney Plus, right? 

They have price elasticity there because they have found a product that people will not do without no matter what the rest of inflation is doing. People won't cut their streaming service. Netflix is able to raise their price a dollar a year, almost every single year, because they have a loyal audience base irrespective of inflation. 

On the flip side, you'll hear about companies like McDonald's bringing back the value meal and Wendy's bringing back the Wendy's Happy Meal or whatever it is because their customers have become much more price conscious and are spending less every time they go in there. So they will lower prices or make incentives. 

Automakers do it all the time as well. If inflation is high and auto prices are high, nobody's buying. Guess what? You're going to get a lot of discounts from the automakers because of inflation. We always say in economics, the cure for high prices is high prices because if consumers eventually tap out and they won't buy anymore. 

Well, until that happens, companies have that price elasticity even in an inflationary environment, but when they stop seeing demand, that's when they start cutting prices and that's when you see inflation recede. 

Cassidy Clement 

So you're really watching like a live basketball game almost to see at what point does the clock run out within that sector for that price elasticity.  

Just speaking in general terms, you know, if that's something that you're looking into is investing in a certain type of sector, keeping an eye on rates, inflation, these other things that goes into the potential performance or maybe even the potential long versus short-term holding that you would have to have in those positions to reach your financial goal, depending on what it is that you set for yourself. 

Caleb Silver 

Absolutely. You have to be aware of that and if you are trying to rotate sectors, you have to pay attention as an investor to your portfolio. You can do that, and it's fun, and you can learn all about it and get really good at it, or you can just buy the market and just ride through the different economic and market cycles that we have and know that the market on average returns somewhere between 8 and 10% a year going back about eighty years. 

Now, is it going to happen every single year? I have no idea, but I like the historical track record. So some people say, I don't have time to build this rebalance or do sector rotation. Okay, that's fine. Buy an index fund or an ETF that can handle the volatility and that you can just depend on and send a couple hundred bucks or whatever you can afford every single month and don't worry about it. Or invest with what they call a robo-advisor and they'll do the rebalancing for you. 

There's all different ways to approach it. But as an active investor, if you're going to be a self-directed active investor, and you want to make sure you're on top of your trends, then you better know what cycles we're in right now.  

And you can look at historical performance of all of these sectors. There's twelve of them, and you can see how they've done through different time periods, and then map out your calendar that way for the rest of the year and look in looking ahead. 

And you can also do this if you own a bunch of ETFs or stocks that are heavy in one sector and there is a change going on in that cycle, you can either sell or you can put what we call stop orders.  

And you can do that through your brokerage firm, which is excellent, to say if this stock loses or this ETF loses 10, 15%, I'm out. 

And automatically stop out of that investment. There's ways to do that. So you don't have to sit there and watch every tick of the stock market yourself. 

Cassidy Clement 

Yeah, exactly. You don't want to be there gnawing your nails to the nub waiting for that price to hit. We have stop orders there, but thank you so much for joining us. You brought up some great points today. 

Caleb Silver 

My pleasure. Anytime. 

Cassidy Clement 

Sure, so as always, listeners can learn more about an array of financial topics for free at www.interactivebrokers.com and interactivebrokers.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening, everyone!