Q3 ETF Sector Leaders And Losers: What To Buy In Q4


The stock market went on a roller coaster in the third quarter. Cyclical sectors, those most tied to economic growth, outperformed, while defensive sectors lagged most in the period.

Materials Select Sector SPDR ( XLB ) surged 3.9% in September and 9.5% in Q3, driven mainly by a sudden turnaround in metals and mining stocks, which had lagged most of the past year.

Materials companies' third-quarter earnings were flat compared with the year-ago period after contracting 8% in the second quarter, according to Thomson Reuters.

S&P Capital IQ analysts recommend that investors underweight materials stocks relative to broad market indexes in the fourth quarter because of volatile commodity prices, weak earnings growth and high valuations. They're trading at 18 times 2013 earnings vs. 15.6 for the S&P 500.

"Subdued global macroeconomic outlook in the U.S., Europe, Japan and many other developed economies, and slowing demand from emerging markets for metals and mining products, is limiting commodity price gains," Alec Young, global equity analyst at S&P Capital IQ, wrote in a report Sept. 26.

Industrial Select Sector SPDR ( XLI ) added 5.3% in September and 8.8% in Q3. Industrials are estimated to grow earnings 5.4% in Q3, just slightly better than the S&P 500's 4.6% uptick.

S&P Capital IQ suggests weighting industrial stocks in line with the broad market "due to expected sales benefits from rising emerging and frontier market exposure, an improving housing-led U.S. recovery, stabilization in Chinese growth in the 7% area, Europe's return to growth and easing U.S. fiscal drag," Young wrote. "In addition, operating leverage is rising with revenues thanks to aggressive cost cutting and manufacturing automation initiatives put in place by most companies during the extreme business downturn of 2008 and 2009."

Third-Quarter Losers

Defensive sectors lagged the most in the third quarter.Consumer Staples Select Sector SPDR ( XLP ) andUtilities Select Sector SPDR ( XLU ) ended the three months nearly flat.

Consumer staples companies grew earnings nearly 5% in the third quarter, an improvement from the 3.4% growth in second quarter. Young rates staples market weight and utilities underweight.

In regards to staples, Young wrote: "Global sales volume gains are expected to be driven largely by higher marketing expenditures, and increased sales in developing markets. However, with U.S. unemployment expected to stay relatively high in 2013, we think less expensive private label goods will remain attractive to many consumers, limiting the sales growth of branded goods companies. In addition, while commodity price inflation has eased, pricing power remains limited due to relatively soft volume growth."

And as for utilities: "With only modest improvement expected in the housing and power markets for 2013, the sector's EPS outlook is below average. However, we still expect the sector's high dividend yield (recently at 4.1%) to at least be maintained, if not rise slightly, and think electric utility revenues and gas utility gross margins will increase."

Utility company earnings were nearly flat year over year in Q3, after declining nearly 4% in Q2.

Sector Bets For Fourth Quarter

Young recommends overweightingConsumer Discretionary ( XLY ),Financials (XLF) andHealth Care (XLV). These returned 7.5%, 6.2% and 2.4% in Q3, respectively.

Young reasons that consumer discretionary should benefit from accelerating economic growth in 2014 as the housing market continues to recover, companies expand foreign sales and tech companies introduce new products. Financials' earnings prospects will improve as long-term interest rates -- at which they lend -- rise and short-term interest rates -- at which they borrow -- are kept near zero by the Federal Reserve.

"European sovereign stress is at manageable levels, helping ease fears of global credit market disruption and boosting investor sentiment towards the sector," Young wrote.

Health care is a cheap, defensive play that should reap profits from new drugs, emerging markets and merger and acquisitions. In addition, drug companies are paying dividends and are more efficient in their research and development.

Discretionary stocks boosted earnings 8% in Q3 year over year and health care 4%. The financial sector, up 10%, increased earnings the most in Q3.

Follow Trang Ho on Twitter @IBD_THo .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ, Inc.

This article appears in: Investing , ETFs

Referenced Stocks: XLB , XLI , XLP , XLU , XLY

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