Causes For Concern With Discretionary Stocks, ETFs

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 ETFs has been the Consumer Discretionary Select Sector SPDR (NYSE:XLY). 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:XLP) and the iShares Dow Jones U.S. Healthcare Sector Index Fund (NYSE:IYH) 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 ETF (NYSE:VCR) is higher by 13.6 percent. The iShares Dow Jones U.S. Consumer Goods Sector Index Fund (NYSE:IYK), 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 personal savings," said Koesterich in his May Market Perspectives piece. "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 names.

"While this is not unusual for the staples sectora high return-on-equity (ROE) and defensive characteristics explain why this sector typically trades at a premiumit 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 forever.

For more on consumer ETFs, click here.