Home Stock Market An 'unprecedented' change to the stock market will create a concentrated sector of trading favorites

An 'unprecedented' change to the stock market will create a concentrated sector of trading favorites

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Technology’s status as the hottest sector on Wall Street may be coming to an end — and not for reasons that have anything to do with the high-flying sector’s fundamentals.

Changes to MSCI’s and S&P Dow Jones’s Global Industry Classification Standard means that September will see the launch of a new communications sector, built largely out of stocks that currently occupy the telecom, technology and consumer discretionary sectors. While the real estate sector was introduced in 2016 with the components spun out of the financial sector, this marks the first time that a new industry group will be created in this fashion.

“The realignment is unprecedented,” wrote Morgan Stanley in an analysis of the upcoming change. “Previously, the only sector change was the separation of real estate from financials in 2016, but this affected a smaller fraction of market cap, was simpler in terms of which stocks could go where, and had a longer lead time for investors to digest.”

The new sector is an attempt to better reflect the primary business of different companies, which often span multiple sector categories and don’t always reflect the industry they’re currently classified in. Telecommunication stocks like AT&T

T, -1.58%

 and Verizon

VZ, -2.14%

 , for example, are currently in the technology sector, while Netflix, one of the most notable internet companies of the current era, is a discretionary name, not a technology one.

Read more about how companies are placed into sectors here

The shift in the creation of the new sector will impact some of the biggest stocks on the market. Walt Disney Co.

DIS, -4.50%

 , Netflix Inc.

NFLX, -1.21%

and Comcast Corp.

CMCSA, -7.38%

 — a trio of stocks that have a combined market capitalization of more than $450 billion — will all move from the consumer discretionary sector to the new communications group, which will cover two primary subindustries of telecom services and media and entertainment. Facebook Inc.

FB, -1.88%

 and Google parent Alphabet Inc.

GOOGL, -2.29%

 — combined market cap: $1.3 trillion — are among the technology stocks moving over.

In other words, three of the five FAANG stocks — a quintet of large-capitalization internet and technology names that have become trading favorites on Wall Street, having contributed a sizable portion of the overall market’s advance over the past year — will be switching sectors, which could mean less demand for a Facebook- and Alphabet-deprived tech sector.

According to data from Morgan Stanley, the new sector will be the third-largest on the market based on market cap, comprising 13.2% of the total.

Courtesy Morgan Stanley

Currently, tech amounts to nearly 26% of the market, and it has 167 components; both represent the highest of any of the 11 primary sectors. The discretionary sector represents 13.4% of the market, making it the third-largest based on Jan. 31 data, and it has 163 components, the second-most.

Courtesy Morgan Stanley

Courtesy Morgan Stanley

The communications sector will only have 60 components, making it the eighth-largest by this metric; Morgan Stanley described it as “mega cap heavy and concentrated” in terms of its holdings.

The higher concentration means the new sector also “has higher stock specific risk, meaning its typical stock is more idiosyncratic relative to standard equity risk factors, than the modified tech sector, and similar or higher stock specific risk to the modified discretionary sector,” the investment bank wrote.

On a valuation basis, Morgan Stanley calculates the new sector will have a price-to-book ratio of 4.09, below both the revised technology group (5.8) and the revised consumer discretionary sector (6.39). It will also have the lowest dividend yield of the three, at 0.79%, compared with 1.6% for discretionary and 1.09% for technology. The forward price-to-earnings ratio will stand at 22.53 for the new sector, while it will be 19.65 for the revised tech group and 24 for the revised consumer sector.

The S&P 500

SPX, -1.27%

 overall has a price-to-book of 3.21, a dividend yield of 1.74% and a P/E of 22.6, according to FactSet data.

For investors, the implication of the change will principally be felt by those who seek exposure to specific industries through passive sector-tracking funds, a category of product that has about $950 billion in assets, according to Morningstar Direct.

Such products — notably popular exchange-traded funds like the Technology Select Sector SPDR ETF

XLK, -1.01%

 — mimic the performance of a sector by holding the same components as the underlying sector’s index, and in the same proportion. In order to accommodate the change, the tech ETF, for example, will have to sell the technology stocks that are moving, while any communication-sector ETFs will have to buy them. In December, Credit Suisse estimated that the new sector could impact 26 ETFs with more than $60 billion in assets, with the $19.6 billion tech SPDR fund the largest of the effected ETFs.

Such trading activity — which will occur regardless of the fundamentals of the relevant securities — could mean short-term volatility in the stocks, although MSCI and S&P Dow Jones will be releasing a full list of the largest impacted companies in August, which could mean that the impact is priced into the shares long before any changes occur.

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