Talk about a topsy-turvy market. Tuesday’s tariffs sparked more market jitters. Consumer confidence is sinking and the federal funds futures market is now pricing in three rate cuts in 2025. That compares to expectations of a single cut just a few weeks ago. Suddenly, bad news for the economy has become bad news for the markets again.

For most of last year, advisors paid little heed to sector selection, given the broader indexes were bolstered by mega-cap tech. But this year, investors cannot count on big tech to continue to prop up the entire market. There’s a lot more volatility bubbling beneath the surface than an index-level view would suggest. In fact, the realized average volatility correlation is near an all-time low — just 0.15% — according to Goldman Sachs. That means there’s a significant and growing disparity between the implied volatility at the stock level and the index level. All this makes a more proactive approach to stock and sector selection increasingly attractive.

Sector ETF Snapshot: Reversal of Fortune

Stocks were full steam ahead after the November presidential election but have swiftly taken a defensive turn to start the year. The S&P 500 has given back all its post-election gains — now flat for 2025 as of Thursday. Many of last year’s market leaders have transformed into laggards. Those include technology and consumer discretionary, the lone two sectors in the red this year.

Tech had been the standout star for the past two years. Technology-focused funds like the Technology Select Sector SPDR Fund (XLK) and the Vanguard Information Technology ETF (VGT) enjoyed strong double-digit gains in 2024. That’s perhaps no surprise, as Nvidia, Apple, Microsoft, and Broadcom make up close to 50% of both funds. On a flows basis, as much as $33 billion poured into tech sector funds, representing 76% of all sector ETF flows in 2024.

But in February, tech ETFs saw $1.5 billion in net outflows. XLK is down 6%, as analysts express concerns over frothy valuations and a relative slowdown in earnings growth.

Source: VettaFi

Healthcare has been the clear winner. It has cemented a top spot among many of Wall Street banks’ sector overweight lists. That’s because of historic underperformance over the past two years and historically low valuations. The Health Care Select Sector SPDR ETF (XLV) is up 9% on a total return basis compared to the S&P’s 2% loss.

However, healthcare ETF flows remain flat on the year. Meanwhile, rate-sensitive consumer staples, real estate, and utilities have all held up well in the face of expectations of an easier Fed policy to stave off a sharper slowdown. The Consumer Staples Select Sector Fund (XLP), the Vanguard Real Estate ETF (VNQ), and Utilities Select Sector SPDR Fund (XLU) have all risen 5%-6% this year. That is due to investors seeking safety in more defensive sectors.

Despite the recent pullback, financials saw renewed interest late last year. That spilled over into the sector again this year. The Financial Select Sector SPDR Fund (XLF) is up 7%. That has led the sector ETF flows leaderboard — to the tune of $3 billion YTD. Many expect the new administration to relax regulatory restrictions on the banks, which have given them a boost. The SPDR S&P Bank ETF (KBE) has risen 2% so far, with a smattering of inflows.

Tariff Takeaways

Trying to allocate based on tariff talk is arguably a fool’s errand, given how fluid the situation appears to be. Rising costs and economic slowdowns threaten to dampen demand across the globe, as countries like China and Canada retaliate. Export-related industries and cyclical, global trade-dependent sectors are most vulnerable right now.

Consumer discretionary spending is set to slow amid rising clothing, travel, and leisure costs. Industrials like machinery and construction risk getting hit by steel and aluminum tariffs, affecting companies like Boeing and Caterpillar. Materials industries like mining, packaging, and chemicals face increased raw material costs.

And while real estate stocks hold up well, homebuilders relying on imported lumber will likely have to contend with rising commodity, labor, and freight costs – putting a further strain on margins. While the Real Estate Select Sector SPDR Fund (XLRE) has risen 7% and seen modest inflows, the SPDR S&P Homebuilders ETF (XHB) is down 5% and has seen net outflows for the year.

The shifting tides of market leadership underscore the growing importance of sector-specific strategies. With last year’s defensive laggards rising to the forefront, and former leaders like technology and consumer discretionary faltering, 2025 may be shaping up to be a year of transition. Investors must navigate heightened volatility, evolving economic dynamics, and the fallout from tariffs with a sharpened focus on sector allocation. Sector ETFs remain a valuable tool in this environment.

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