Last week, I wrote that you should think about ETFs as the Lego building blocks of investing.
Just like a toddler who can build anything he wants to with multicolored and differently shaped Lego blocks, you can use ETFs to custom create the portfolio you want.
This week, I’ll show you how to put this Lego building block investment theory into practice by betting big on the U.S. stock market sectors set to rally as a result of Trump’s tax reform.
The S&P 500: A Collection of Sectors
When most investors think of the U.S. stock market, they think of the S&P 500 Index.
No wonder the SPDR S&P 500 ETF (NYSE: SPY) is the granddaddy of all ETFs.
Tracking the S&P 500 Index, this ETF trades an average of 81 million shares per day. The ETF’s massive market cap of $274 billion is equivalent to that of the 11th-largest U.S. company.
Like the S&P 500 itself, the S&P 500 ETF is weighted by market capitalization.
Apple (Nasdaq: AAPL) is the largest single S&P 500 component, weighted at 3.8%.
Rupert Murdoch’s News Corporation Class B (Nasdaq: NWS) is the smallest component, accounting for a mere 0.01% of the ETF.
Market capitalization is just one way to think about stocks in the S&P 500. But you can also think of the S&P 500 as a collection of market sectors.
A market sector is a grouping of companies that have similar business characteristics. (Granted, this is an expansive definition.)
Even though Wal-Mart and Tiffany & Co. serve very different clientele, they are both parts of the same consumer discretionary sector.
Standard & Poor’s divides the S&P 500 into the following 10 sectors:
1. Consumer Discretionary
2. Consumer Staples
7. Information Technology
9. Telecommunication Services
State Street Global Advisors has developed ETFs for each of these sectors. That means you can buy an entire sector with the click of a mouse, paying the same commission for a whole sector as you would for a single stock.
The Magic of Market Sectors
So why should you invest in a specific market sector versus just buying the entire S&P 500?
It’s the same reason Willie Sutton gave in his memoir when the police asked him why he robbed banks.
“Because that’s where the money is.”
All S&P sectors have their seasons. And each year, some sectors outperform others.
Let’s look at the most recent numbers…
The S&P 500 ETF has gained 20.9% over the last 52 weeks.
Over the same period, some S&P 500 sectors performed both much better and much worse.
On the upside, the Technology Select Sector SPDR ETF (NYSE: XLK) generated a 35.2% return.
On the downside, the Energy Select Sector SPDR ETF (NYSE: XLE) actually lost money in a year when every other sector was up.
Had you held those in your portfolio, just two tweaks – overweighting technology and underweighting energy – would have boosted your investment returns substantially compared with holding the S&P 500 ETF alone.
Trump’s Tax Reform: A Once-in-a-Generation Opportunity
Comprehensive tax reform on the scale of the bill Trump signed in December comes along once in a generation.
Accountants, tax lawyers and analysts are still parsing the details to assess its implications.
But the sector-level implications are already apparent.
As Oxford Club Editorial Director Mathew Benjamin said recently, the Trump tax reforms are a game changer for three sectors: healthcare, finance and energy.
I agree… and would also add the technology sector to that list.
All U.S. companies will theoretically benefit from the corporate tax rate dropping from 35% to 21%, especially those in the financial sector.
KBW Research estimates the dramatic cut to the corporate tax rate will drop straight to the bottom line of banks like JPMorgan Chase, Wells Fargo and Bank of America.
Drug companies in the healthcare sector now have substantial tax incentives to repatriate funds held abroad. Shareholders will reap the benefits as those companies invest in core businesses, buy back shares and boost dividends.
The technology sector has already enjoyed lower tax rates. According to Moody’s, Apple, Microsoft, Alphabet, Cisco and Oracle held 88% of their money overseas at the end of September. Four of these companies alone (minus Alphabet) could repatriate $456 billion to U.S. shores.
Finally, energy, which was 2017’s worst-performing S&P 500 sector, may be the single most significant beneficiary of Trump’s tax reform.
Aside from paying a higher average effective tax rate (36.8%) than the aggregate S&P 500 (30%), energy companies will now be able to deduct capital expenses immediately. That means a significant boost to their bottom lines.
Most of Wall Street is making bets on where the overall stock market will be at the end of 2018.
I think it’s much more profitable to focus on the S&P 500 sectors that have the most to gain from the recent Trump tax reform.
And you can bet on each of these sectors through S&P 500 Sector SPDR ETFs:
1. Technology Select Sector SPDR (NYSE: XLK)
2. Financial Select Sector SPDR (NYSE: XLF)
3. Health Care Select Sector SPDR (NYSE: XLV)
4. Energy Select Sector SPDR (NYSE: XLE)
Thoughts on this article? Leave a comment below.