Sector investing has become increasingly popular in recent years, no doubt in part because of the availability of exchange-traded funds such as the Select Sector SPDRs that facilitate easy exposure to the desired sector.
Below is my take on the investment outlook for each of the nine Sector SPDRs, based on the fundamentals of the constituents that make up the funds.
There is also a short table showing consensus EPS for each fund as well as its P/E ratio. Investors seeking more detailed fundamental data can go to the Sector SPDRs Web site and look for the Sector Analyzer Report under
. You can also check out TheStreet.com's own
Consumer Discretionary SPDR
: I'm not a bear on the U.S. consumer per se, but earnings estimates for XLY simply appear too optimistic to me, since they are predicated on a big increase in margins to levels never before achieved.
Estimates are in free fall, yet XLY has the highest P/E of any sector -- higher than even technology!
Consumer Staples SPDR
: Earnings for companies in XLP are forecast to grow faster than earnings for the
this year, and this may make the sector a good defensive play, but XLP already trades at a premium to the market.
Plus, the sector's return on equity has been falling for years, and this poses an additional threat to valuations, given its high price-to-book value multiple. (There is a high correlation between ROE and P/BV, so falling ROE could mean lower P/BV multiples in the future.)
: Earnings are expected to be down slightly this year, but with oil prices surging again, that could prove pessimistic. At any rate, times are good for energy companies, and XLE, which trades at the lowest P/E of any sector SPDR, may still offer good investment potential for serious long-term investors (more than five years) regardless of near-term fluctuations in oil prices, since by my analysis, XLE is cheap relative to cycle average profitability.
: Turmoil among subprime mortgage lenders does not as yet appear to have affected the earnings of the financial sector overall. In fact, 2007 earnings estimates for XLF actually rose over the past month -- the only sector that saw an increase.
Our belief is that the large banks and brokers that dominate the sector will not see a spillover effect, and in any case the boom in M&A activity that is bringing tremendous fees to Wall Street will more than compensate for any mortgage-related risk that was not sufficiently hedged. Therefore, I believe earnings estimates could actually prove conservative, and EPS growth is currently forecast to be about as fast as for the S&P 500. Despite this, XLF trades at a substantial discount to the market on most valuation metrics.
: There could be upside to current EPS estimates, given recent strength in export demand and this sector's relatively large foreign sales -- which are more than a third of overall sales -- and because they also tend to benefit from a weaker dollar. At any rate, current estimates still see faster earnings growth than the S&P 500 in 2007, but shares of XLI already trade at a slight premium to the market, so they are probably not a bargain.
Health Care SPDR
: Upside potential for XLV, which already trades at a premium P/E to the S&P 500, seems limited: Health care is the only sector for which EPS growth trailed sales growth over the past five years, in part because of persistent declines in return on equity. And the drug companies, which dominate the index (about two-thirds of assets), are unlikely to get much help from headlines coming out of Washington, given the Democrats' control of Congress.
: Estimates have been falling, and investors may have to wait until 2008 to see the kind of earnings growth that tech is supposed to deliver. And valuation is always a concern: XLK is trading at more than 19 times current-year estimates.
: Current consensus estimates imply that firms in XLB are at or near peak profitability and that earnings growth will be minimal in 2007, although that obviously depends on the future direction of commodity prices. XLB trades on par with the S&P 500 and is still considerably more expensive than another highly cyclical sector: energy.
: Consensus earnings estimates suggest fundamentals remain solid, and XLU offers the highest dividend yield of any Select Sector SPDR. However, steady gains of more than 100% since early 2003 have resulted in higher multiples which, in turn, may depress returns going forward.
Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.