On the surface, 2023 has been a banner year for the stock market, with the S&P 500 up 20.4% year to date and the Nasdaq Composite up 37.9% year to date. But dig deeper, and you'll realize that the gains almost entirely come from a knockout performance from three massive sectors: technology, communications, and consumer discretionary.
Here's what you need to know about each sector and whether it's a buy for 2024.
Image source: Getty Images.
The Magnificent Seven belonged to these sectors
The Technology Select Sector SPDR Fund (XLK 1.13%), The Communication Services Select Sector SPDR Fund (XLC 2.76%), and the Consumer Discretionary Select Sector SPDR Fund (XLY 0.90%)are three exchange-traded funds (ETFs) that do an excellent job mirroring the performance of their respective sectors.
As you can see in the above chart, all three sectors are outperforming the S&P 500 year to date. Combined, they make up a staggering 48.4% of the S&P 500, which illustrates the impact these sectors can have on the market.
The Magnificent Seven belonged to these sectors
Bank of America analyst Michael Hartnett coined the term, "Magnificent Seven", to describe the seven stocks, Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL), Amazon (NASDAQ: AMZN), Nvidia (NASDAQ: NVDA), Meta Platforms (NASDAQ: META), and Tesla (NASDAQ: TSLA). It's often thought of as referring to technology stocks.
In reality, Meta and Alphabet make up about 47% of the SPDR communications sector index, Amazon and Tesla make up about 41% of the consumer discretionary sector index, while Apple and Microsoft make up nearly 45% of the tech sector index, with Nvidia contributing another 4.5%.
The takeaway is that all three of these sectors are heavily influenced by the Magnificent Seven. And because the Magnificent Seven stocks are all outperforming this year, it makes sense that communications, consumer discretionary, and tech are outpacing the market's gains.
The tech sector
One of the reasons the tech sector continues to outperform the broader indexes is its structure. Out of all the sectors in the stock market, tech stands out as striking a nice balance between proven cash cows and exciting high-growth companies.
Apple and Microsoft anchor the sector. Despite trading at a premium to the market, these stocks aren't terribly expensive. They have plenty of cash flows to pay dividends, buy back their own stock, and invest in growth. Then, you have some massive, high-octane growth stocks like Nvidia that are going to play a pivotal role in powering artificial intelligence (AI).
The tech sector features a nice blend of consumer-facing and business-focused companies, enterprise software from companies like Adobe and Salesforce, and chip companies including Nvidia, Advanced Micro Devices, Broadcom, Qualcomm, and Intel.
The two biggest downsides of tech are its valuation and its cyclicality. Tech investment and growth are heavily dependent on the broader economy, which makes sense given tech is (by far) the most important sector in the U.S. stock market. The price-to-earnings (P/E) ratio of the tech sector, according to the SPDR sector fund, is 35.7. That's quite the premium compared to the overall market, represented by SPDR S&P 500 ETF Trust (NYSEMKT: SPY), which clocks in a P/E ratio of 23.3.
Overall, tech is arguably the highest-quality sector in the entire market. But for it to do well in 2024, earnings have to grow because it's hard to see the sector trading at a 40 or 50 P/E ratio.
The consumer discretionary sector
Consumer discretionary is interesting because there are a lot of different themes at play. Unlike Apple and Microsoft, which are two massive tech stocks with some overlap and very similar capital allocation strategies, the two largest companies in the consumer discretionary sector are very different and have virtually no overlap. That's basically the theme across the sector.
The top five largest companies are Amazon, Tesla, McDonald's, Home Depot, and Nike -- five completely different companies in five different industries.
The advantage of the consumer discretionary sector is that it has more variety than other sectors. McDonald's and Home Depot are dividend-paying value stocks, not growth stocks like Tesla and Amazon. Even Nike is long past its torrid growth rate and is more so a balance between growth, value, and income at this point.
Like tech, consumer discretionary is highly cyclical and volatile. This sector is a better value than tech, with a 27.1 P/E ratio.
The communications sector
Communications is by far one of the strangest sectors in the stock market. It blends telecommunications (high-yield dividend giants like AT&T and Verizon Communications) with legacy media companies and cable providers, streaming companies, and social media.
It gets tricky when you consider Alphabet owns Google Cloud, which has little to do with communications and is more tech focused, just as Amazon Web Services falls under consumer discretionary by default when the subsidiary on its own should be in the tech sector.
At the end of 2022, I predicted that the communications sector would dominate 2023 largely because Alphabet, Meta Platforms, Netflix (NASDAQ: NFLX), and Walt Disney (NYSE: DIS) were so beaten down, along with other top holdings in the sector.
But going into 2024, I think this is a sector where investors are better off selecting individual stocks based on what they are targeting instead of buying the whole sector. After all, Meta Platforms is one of the best-performing stocks in the whole S&P 500 this year. And some folks may prefer Microsoft as a better overall AI play than Alphabet, while others may prefer to pick Netflix or Disney instead of buying both.
The sector sports a P/E ratio of 26.4, but the valuations of its top holdings vary wildly depending on the industry.
Compelling opportunities for 2024
December is the perfect time to reflect on what moved the market this year and what may move the market next year. It's also a good time to recall the importance of individual stocks, particularly the Magnificent Seven, and their effect on the overall market and certain sectors.
In terms of buying a sector for next year, I'd say technology stands the best chance at outperforming the S&P 500, consumer discretionary is still a solid overall value and would be the best foundational investment for building a diversified portfolio, and communications is probably the worst of the three to buy outright, but has some compelling turnaround opportunities, particularly in Disney.
However, it's important to understand that all three sectors underwent massive run-ups in 2023 and could stall out in the short term, which is why it's best to invest with at least a three- to five-year time frame to avoid the fortune (or misfortune) that results from whatever the market is feeling at the time.
