Eyeing Bigger Gains, Investors Shift from Consumer Staples to Cyclical Stocks

Since the New York Stock Exchange's inception in 1792, the market has experienced a never-ending cycle of booms and busts. And despite the S&P 500's recent sell-off, it appears that the cycle is once again firmly in bullish territory. The most obvious evidence of this comes as investors have begun dumping consumer staples stocks in favor of cyclical stocks.

Consumer staples make for popular investments amid bear markets as they're considered inelastic in demand and offer investors' portfolios a layer of protection from downturns. Such was the case throughout much of 2022 as the S&P 500's consumer staples finished third-best among all 11 sectors on the back of steady gains by companies like Coca-Cola and JM Smucker. And for companies in that sector that posted losses in 2022 — like Colgate-Palmolive, Costco and Target — it paled in comparison to the losses suffered by tech sector giants, including Alphabet (-35.2%), Amazon (-48.3%), Tesla (-64.02%) and Meta (-64.4%).

However, with the market rebounding in 2023, consumer staples posted the third worst performance among all sectors. Then this past March, with investors injecting almost $100 billion in equity ETFs, the sectors leading those inflows included industrials, materials and energy — corners of the market typically lumped into the category of cyclical investments.

Cyclical stocks include companies that are beholden to all of the economy's booms and busts, doing very well when the economy is hot and poorly when it's not; think of companies like Chipotle, LVMH Moët Hennessy Louis Vuitton or Disney as some examples. Meanwhile, ETFs seeing the most outflows are those in the healthcare and consumer staples sector, both of which are intrinsically defensive in nature.

The news makes for a perfect example of the use investors have for staples and cyclicals. Many people are already invested in both types of stocks if they have a well-diversified portfolio. But whether investors hold more consumer staples or cyclical stocks is often determined by the state of the economy. Knowing how to wield this knowledge can help protect portfolios when it's needed most, and grow them when opportunities arise.

A pivot to cyclicals, despite interest rates remaining high and despite inflation remaining sticky, evidences bullish sentiment, as investors tend to take on more risk when the economy is booming.

Here’s what you need to know about these two fundamental asset classes and the possible direction of the market in the near term to medium term.

Consumer staples stocks

No matter what part of the market cycle we find ourselves in or what shape the economy is in, investors typically have funds allocated to consumer staple stocks. These staples are, as far as consumer stocks go, some of the safer investments one can have.

The consumer staples sector includes companies that manufacture and retail products that are considered essential — things that people will purchase regardless of their economic situations. Think: needs rather than wants. Food and beverage stocks make up a large portion of consumer staples, as do companies that make medications, hygiene supplies and household cleaning products. It also includes products that many wouldn't consider staples, such as tobacco, alcohol and even candy.

Despite staples being called big and boring, investors buy shares of these companies — especially during times of stock market underperformance — because they’re reliable. They usually don’t experience sudden depreciation when the economy sours because people can’t stop buying food or medicine, and many are unwilling to forgo things like cigarettes and alcohol even during a recession. In fact, consumer staples have outperformed the S&P 500 during all three recessions so far in the 21st century. Diversifying a portfolio with exposure to consumer staples provides investors with some stability that isn’t afforded by high-growth, high-volatility sectors like tech.

As for appropriate portfolio weighting, though, consumer staples shouldn’t be the star. While they are averse to volatility, the gains one can expect from these stocks are quite limited, even during a healthy market. The S&P 500 Consumer Staples Index returns about 11% annually, compared to the 14% annual return of the broader S&P 500.

Recently, staples have especially underperformed when compared to other “safe” investments like Treasury bills, certificates of deposit or bonds. In 2023, consumer staples took a hit because investors were more drawn to CDs and high-yield savings accounts, which offered guaranteed returns of 5% or more thanks to high interest rates as a result of the Federal Reserve's monetary policy.

The central bank's interest rate-hiking policy was meant to tame inflation and bring down the cost of consumer staples and other products, but inflation proved stickier than the Fed anticipated, which hampered the performance of stocks in that sector.

Cyclical stocks

Consumer staples and cyclical stocks, which can also entail equities in the consumer discretionary sector, are two sides of the same coin. Whereas consumer staples are the bare necessities, cyclicals make up all of the fun products and services consumers might want, but don’t necessarily need.

Consumer discretionary's fluctuating demand can be exemplified by scrutinizing the sector's performance during 2022's bear market, and again by its performance in 2023 during the market's recovery. In 2022, the consumer discretionary sector posted a loss of -37% and finished second to last among the S&P 500's 11 sectors. Last year when the market entered bull territory, it finished third best with a +42.4% gain.

Examples of companies offering exposure to cyclical stocks include clothing producers, airlines, automakers, restaurants and even home appliance manufacturers. The common thread here is that people are willing to splurge on many of these products and services when the economy is doing well and they have the extra cash, but they’re also the first things consumers cut from their budgets when financially constrained.

It’s worth noting that cyclical stocks include many companies that sell products and services directly to the end user, but others aren’t as obvious as Starbucks, Ford or United Airlines. Stocks in the energy and material sectors, for example, are highly cyclical, tending to underperform when the economy is doing poorly and demand falls for things like new infrastructure construction.

This is illustrated by the energy sector's performance in 2020 when the COVID-19-induced recession resulted in plummeting oil demand, which saw the sector finish last that year with a -33.7% loss. However, in 2022 when the price of gas hit its all-time high and the stock market began turning around, the energy sector posted gains of +65.7%.

That's been the case this year, as well, with the energy sector posting a year-to-date gain of +13.4% compared to the consumer staples sector's +4.2%, with company's like Devon Energy, Plains All American Pipeline and ExxonMobil posting YTD gains of +13.7%, +17% and +17.8%, respectively.

Which sector should investors turn to?

When the market is healthy, cyclical stocks tend to outperform consumer staples. The S&P 500 Consumer Discretionary Index sees an average annual return of almost 17%. Last year, that index returned over 42% (third best among all sectors), while consumer staples limped to the finish line, returning only a half of a point (third worst).

But mind you, when times are tough, cyclicals do exceptionally poorly, as demonstrated by the consumer discretionary's aforementioned performance in 2022. In a severe enough recession, companies operating in the cyclical space face greater risks of insolvency or failure than those in the consumer staples sector that people continue to depend on.

For investors looking for higher growth potential during bull markets, cyclical stocks can provide more upside. But for safety-oriented investors, consumer staples continue to provide a safe haven. Ultimately, the decision of where to invest is determined by individual investor preferences, but diversifying with exposure to each of these sectors can provide the best of both worlds.

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