Discretionary ETFs Are Getting Pricey

Exchange traded funds tracking consumer discretionary stocks have been impressive performers this year.

The Consumer Discretionary Select Sector SPDR (NYSE:XLY) highlights as much as that ETF is the third-best performer of the nine sector SPDR funds this year. XLY trails only its health care and financial services equivalents.

Over the past three years, however, XLY stands as the only somewhat risky SPDR that has outpaced lower beta fare such as the staples and health care funds. Other discretionary funds have been stellar performers as well.

For example, the iShares U.S. Consumer Services ETF (NYSE:IYC) and the Vanguard Consumer Discretionary ETF (NYSE:VCR) are up an average of 25 percent year-to-date.

It is trailing performances like those that could be signs that investors looking to grab discretionary sector exposure will pay up for the privilege. Russ Koesterich, global chief investment strategist for iShares, says some recent economic trends show the discretionary sector is richly valued.

"The shifting nature of the job market and weak income growth are also significant headwinds facing US consumption," said Koesterich on the BlackRock blog. "In June, higher mortgage rates seemed to take some of the wind out of the housing market's sales. If this were to continue, it would remove one of the big props holding up the US consumer. As such, consumer-related companies continue to look expensive."

Koesterich also points out that the price-to-book ratio of discretionary stocks compared to the S&P 500 is high, currently around 1.7. Three years ago, the ratio was 1.2 and at 1.7 today, that is nearly double what was seen during some of the boom times of the mid-1990s.

"And as of last Friday, US consumer discretionary companies traded at nearly 4x book value about a 70% premium to the broader market. In other words, investors are currently paying a big premium for retailers and restaurants at a time when consumers are still struggling and spending remains weak," said Koesterich.

Rich valuations are seen with ETFs as well. XLY's P/E ratio is close to 19 with a price-to-book ratio of 3.8. Those numbers for IYC are 20.8 and 5.3, though in the case of IYC, its valuations are inflated by its exposure to staples names such as Wal-Mart (NYSE:WMT).

It is easy to see why some discretionary ETFs are richly valued. Amazon.com (NASDAQ:AMZN) wit a forward P/E of almost 97, is a top-10 holding in both IYC and XLY. After soaring 26.5 percent this year, Home Depot (NYSE:HD) now looks frothy at over 18 times next year's estimated profits.

Caution could be warranted going forward with discretionary ETFs because the sector, as Koesterich notes, could be "discounting too much optimism."

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