The Two Types Of ETFs You Should Be Avoiding Right Now

If you're positioning your portfolio to how the economy is looking today, there are specific areas of the market to underweight.
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The S&P 500 (SPY) and Nasdaq 100 (QQQ) continue pushing towards new all-time highs, but conditions aren't quite as bullish for all areas of the market.

From the March 2020 low through March 2021, cyclicals had mostly been outperforming the broader market (although financials and energy took more time to get it into gear as rising interest rates and expectations for higher global energy demand didn't materialize right away). Tech stocks never really stopped leading. Defensive sectors, such as consumer staples, had a very brief moment in the sun before yielding to growthier areas of the market again.

In March of this year, the tides turned again. Fresh on the minds of investors now are concerns about spiraling short-term inflation rates and the fact that post-COVID growth rates appear to have peaked. It looks like we are shifting from the rapid growth phase of an economic recovery/expansion into a more mature stage. This tends to favor growth areas of the market, since the economy is still in a good place, but can be challenging for cyclicals as the narrative shifts to slower growth.

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Since March, we've seen small-caps, materials, industrials, financials, energy and dividend stocks mostly underperform the market. The value trade, which had been showing promise has also fizzled.

If you're positioning your portfolio to take advantage of how the economy and equity markets are looking today, there are some areas that are worth avoiding for the time being. Tech and communication services look favorable. Consumer discretionary might be iffy if inflation affects consumer spending. Cyclicals are in the midst of a commodity price reset and defensives seem off the table for the time being.

Above all else, there are two themes that I would be staying away from for now.

Value Stocks

This is sort of an extension of the argument I just made above. We know that value tends to have a higher correlation to cyclicals than growth or defensives. Bank stocks tend to come with lower valuations and pretty much have since the end of the financial crisis. Other financial sector segments, including insurance companies and asset management firms, fall into a similar boat.

Energy stocks also tend to fall into this bucket. There are a fair number of cash-rich companies at reasonable valuations, which could be attractive under different circumstances, but political risks, oil price swings and global energy demand worries have all been working against the group. Energy was one of the market's best performers coming out of the COVID low, but it's begun falling into the laggard category again.

The biggest factor, however, is the economic narrative. Even if rising COVID infection rates don't accelerate the slowing growth trend and inflation risks prove to only be temporary and the Fed doesn't begin backing off its support for the financial markets, the fact that it looks like we're past peak growth for this recovery doesn't bode well for cyclicals and, by extension, value stocks. We knew this day was coming and it's already begun playing out in equity prices.

ETFs with heavy value tilts are prime candidates to become underperformers. The Vanguard Value ETF (VTV), for example, has more than 40% of its assets in the four primary cyclical sectors compared to 25% for the S&P 500. The iShares Russell 1000 Value ETF (IWD) is also around 40% exposure. The iShares MSCI USA Value Factor ETF (VLUE) might be a comparatively better option at 25%.

Either way, given where we are in the economic cycle, it's a little more challenging to make the argument for cyclicals and value stocks today. Growth is still notably expensive and top-heavy in the major indices, but I think investors will continue to gravitate towards these sectors for both capital growth potential and a defensive presence.

Momentum Stocks

This might seem like a bit of a counterintuitive pick, but let me explain.

Staying away from momentum stocks has everything to do with the rebalance schedule. The iShares MSCI USA Momentum Factor ETF (MTUM), for example, rebalances itself on a semi-annual basis, the latest of which took place in May. When selecting components for its index, MTUM looks at relative price action over the past 6- and 12-month periods. Which areas of the market have largely performed the best from May 2020 through May 2021? Value and cyclical stocks. Now, we're back to the same argument I made against value stocks earlier.

MTUM, which had been heavily growth-oriented earlier this year, has half of its portfolio in cyclical sectors, including a whopping 31% in financials. Sure, if interest rates begin rising again, MTUM and other momentum and bank ETFs could look more attractive, but rates have mostly been steadily falling despite a 5% inflation rate. Given the current composition of these funds, the momentum factor doesn't have a bright short-term outlook, but revisit this fund again in November when the next rebalance could shift it away from cyclicals again.

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