How to Pick Sectors for a Long-Term Portfolio

At this time of year there is no shortage of “how to invest in the New Year” articles in the financial media. But this annual ritual is not in alignment with all investors. It also suggests that markets have calendar-year cycles, which is rarely the case.

Certainly short-term tactics can be implemented within a long-term portfolio objective. But when it comes to picking sectors, investors can ironically increase market risk and make their portfolio management more difficult by trying to identify sectors that will outperform over a 12-month period.
While economic and market cycles can be defined and identified, and thus sectors can be chosen accordingly, the holding period is nearly impossible to predict. Furthermore, these cycles are rarely one year in duration, and even more rarely do they coincide with a calendar year.

Look Beyond One-Year Periods to Choose Your Sectors

So what is the best way to pick sectors for your long-term portfolio? The short answer is look beyond a one-year holding period.
In my investment advisory practice, I find it much easier (and much more successful) to buy sectors with the assumption that the holding period will be three years. This same portfolio management idea can also be used for asset allocation strategies.
For example, as of this writing, it is easily arguable that the next three years will include a major market correction (i.e. a bear market decline of more than 20%). If such a correction does not occur, it will be the second-longest bull market since the Great Depression.

Choose Sectors Based On the Business Cycle

Extending this example using the next three years, we may then make further assumptions about which sectors to choose, based upon the business cycle. The late-cycle phase is primarily defined by higher relative inflation and rising interest rates, capped by slowing growth.
Also keep in mind that the recessionary phase is typically less than one year but has tremendous negative impact on almost every equity sector. Therefore, both of these phases are assumed to occur in the next three years.
Here’s how I narrow down my choices, considering the 2015 through 2017 expectations:

• Consumer cyclicals can do well in the late-cycle phase but the consumer defensive sector can remain positive, while having less downside risk during recession, and thus the latter will likely do best in our three-year period.
• You’ll want to avoid sectors, such as financials, real estate, industrials and information technology that typically perform best in the early- and mid-cycle phases but may perform worst in recessions.
• The energy sector is an outlier now because it can perform well in the late-cycle phase. You may consider this a contrarian move or deep-value play, but make sure you plan to hold it for at least three years if you buy it now.
• What remains are utilities and health care, which are sectors that can outperform in both the late-cycle and recessionary periods.

Therefore, you have at least four sectors to choose from (consumer defensive, health, and utilities) and one potential outlier (energy). And as an alternative consideration, though not an industrial sector, gold is typically a price leader during recessions.
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