Cyclical vs. Defensive: What We Learned from 2020

Historically, investors have defined cyclical stocks as those that perform well when the economy does well and defensive stocks as those that can weather the storm regardless of market conditions. However, despite a turbulent year, that’s not what we saw in 2020.

Here I present what we saw in terms of performance of cyclical vs. defensive sectors, how Tesla’s impressive run impacts the overall market, and what to watch in 2021.

Cyclical Stocks Outperformed Defensive

For this analysis, I used FactSet’s economic sector classifications for the Russell 1000 with the sectors categorized as shown in the table below.

Classification of FactSet Economic Sectors

*Hotels/Resorts/Cruise Lines, Casinos/Gaming, and Restaurants are classified as Consumer Services but have been moved to Cyclical for this analysis, which is why the group appears under both Cyclical and Defensive.

In March 2020, when there was extreme uncertainty (strict lockdown enforcements, travel restrictions, and companies shift to working from home), defensive stocks did what they were supposed to—they held up and outperformed throughout the second quarter of 2020. However, looking at cumulative returns, cyclical stocks rebounded quickly and ran away the rest of the year. We did see another dip in October when the second wave of coronavirus cases hit but that was also present in defensive names.

To put additional perspective surrounding the outperformance of cyclical stocks, the Russell 1000’s total return for 2020 was 20.97%. Cyclical stocks returned 24.14% compared to defensive stocks with a 12.96% total return.

In terms of contribution, it is not surprising to see which industries stood out. For cyclicals, the highest contributors were all agile industries like Packaged Software (i.e., Microsoft) and Internet Retail (i.e., Amazon) that were well equipped to operate in a remote workplace. The lowest contributors were Major Banks, Aerospace, Defense (i.e., Boeing), REITs, and Oil.

As far as defensive names, medical companies working on vaccine development and TV/streaming services like Netflix stood out as outperformers. Major Telecommunications, Utilities, and Tobacco lagged the market.

Tesla Skews Everything

When we dig deeper, most of this cyclical outperformance comes from our usual suspects: Tesla and tech. What is surprising here is just how prominent the Tesla effect really is.

Tesla’s total return for the year was 743%, by far the highest in the benchmark. It contributed 1.63% to the overall benchmark return despite having less than a 1% weight. It is surprising that an electric car company outperformed Moderna—a biotech company that came up with a vaccine to help mitigate a global pandemic—by over 300%.

In the following charts, cyclical sectors are shown in blue and defensive sectors in green. With Tesla included, we see Consumer Durables as the outlier. The sector outperforms with the second-highest volatility of all sectors.

With Tesla excluded, this looks like a different chart. Here the trend line and dispersion are more apparent. We see high-volatility cyclical sectors like Energy and Industrial Services with negative performance, yet low volatility defensive sectors such as Communications, Consumer Non-Durables, and Health Technology did not see much benefit in terms of absolute performance. We see cyclical outperformance from the sectors you might expect—Retail Trade, Technology Services, and Electronic Technology—while not adding much in relative volatility. Then we see a cluster in the middle, indicating moderate returns and volatility, which is where Consumer Durables lands without Tesla.

Examining P/E Ratios for 2021

Now that we’ve examined performance and volatility, what can we expect to see in 2021? I’ve excluded Tesla here again to normalize the results. Otherwise, with its 1,400 P/E included in the sector-weighted average, this is what we see:

Without Tesla, cyclical sectors such as Commercial Services, Technology Services, and Consumer Durables are all trading below their trailing 12-month average price-to-earnings ratio. Additionally, we see that almost all defensive sectors are trading above their historical P/E ratios despite having had a rough year in 2020. We could also look at the three- or five-year averages to get a longer-term valuation picture.

Conclusion

Overall, 2020 was an incredibly challenging year. Surprisingly, cyclical stocks performed better than defensive stocks even against the backdrop of a global pandemic and economic recession. As we consider the market environment in 2021, we have a new administration in the White House, ramped-up COVID-19 vaccine distribution, additional fiscal stimulus, and pent-up demand for travel and leisure. However, at the same time we are seeing downward revisions to GDP growth forecasts, a slowing job market, and weak consumer spending.

While evaluating tactical sector allocations for 2021, it is important to re-examine the year we just had and how the uncertainty did not benefit defensive names as we’d normally expect. This may be because 2020 was anything but normal but may also indicate a larger shift to markets.

We will continue to track these trends of cyclical and defensive names in the upcoming year.