As reluctant as many investors may be to admit it, the leading
sectors among U.S. stocks over the past three years are decidedly
defensive. Meaning consumer staples,
health care and utilities
have lead the market higher.
However, the second-best performer of the nine sector SPDR
has been the Consumer Discretionary Select Sector SPDR (NYSE:
). XLY and related ETFs represent the only somewhat risky sector
funds that have been able to really keep pace with the likes of
the Consumer Staples Select Sector SPDR (NYSE:
) and the iShares Dow Jones U.S. Healthcare Sector Index Fund
) over the past three years.
That stands to reason as discretionary stocks have rebounded
on the back of improving consumer sentiment and confidence data
along with improvements in the U.S. housing market. Discretionary
ETFs have again been stellar performers this year. Year-to-date,
XLY is up 14.2 percent while the rival Vanguard Consumer Staples
) is higher by 13.6 percent. The iShares Dow Jones U.S. Consumer
Goods Sector Index Fund (NYSE:
), which is a mix of staples and discretionary names, has
outpaced its rivals with a gain of 17.1 percent.
That all sounds good, but investors may want to take a
cautious approach to discretionary stocks and ETFs, particularly
over the long-term. As iShares Chief Global Investment Strategist
Russ Koesterich points out with regards to the U.S. consumer,
"significant structural headwinds remain."
"Specifically, most US households are still facing an
environment of stagnant real income, an increasing dependency on
two earners, a creaking entitlement system and inadequate
said Koesterich in his May Market Perspectives
. "All of which are likely to lead to a future in which
consumption is a smaller portion of the economy than it has been
over the past 70 years."
Given the sharp out-performance of consumer-related shares
relative to the broader universe of U.S. stocks over the past
several years, it is not surprising that discretionary and
staples names share something in common. That
being frothy valuations
. In the case of staples, the sector is often richly valued and
it indicates that since 2010 investors have either doubted the
rally or have been willing to pay up to play defense. The
valuation issue is arguably more concerning with discretionary
"While this is not unusual for the staples sector-a high
return-on-equity (ROE) and defensive characteristics explain why
this sector typically trades at a premium-it is not the norm for
the consumer discretionary sector," said Koesterich. "Given the
cyclical nature of this sector, consumer discretionary stocks
have normally sported valuations that are, on average, in line
with the broader market. Today, however, the sector is trading at
a 65% premium to the S&P 500, by far the largest premium
going back to 1995."
At the ETF level, XLY currently sports a P/E ratio of nearly
17.5 and a price-to-book ratio 3.63,
according to State Street data
. IYK, perhaps due to its exposure to staples stocks, is even
pricier with a
P/E of 20.8 and a price-to-book ratio of 6.47
Underscoring the potential vulnerability faced by
discretionary stocks going forward is sub-par U.S. consumption
and income growth trends. Clearly, betting against ETFs such as
VCR and IYK over the past several years has proven foolhardy, but
current valuations are implying the arrival of economic data the
U.S. economy may not be able to deliver on.
"What is surprising is the magnitude and consistency of the
outperformance (of discretionary stocks)," said Koesterich. "To
say that the advance has gotten ahead of the fundamentals is an
understatement. Today, by most metrics the sector looks extremely
expensive. Investors have effectively discounted a normalization
in consumption patterns that may never happen.
"Valuations at these levels imply a much faster rate of
consumption and income growth than we are likely to see. As a
result, we would stick with our cautionary stance on the consumer
sectors, particularly the more discretionary companies."
In the essence of fairness, it should be noted that IYK, VCR
and XLY are all trading within pennies of new 52-week highs
Wednesday. Then again, that does not mean the party will last
For more on consumer ETFs, click
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