A Glum View On A High-Flying Sector

The consumer discretionary sector, the fourth-largest sector weight in the S&P 500, was the best-performing group in the benchmark U.S. index last year as the Consumer Discretionary Select Sector SPDR XLY was the top performer among the nine sector SPDR exchange trade funds with a nearly 10 percent gain.

In fact, XLY was last year's best diversified consumer discretionary ETF as its fortunes were boosted by the likes of Amazon.com Inc. AMZN, Home Depot Inc. HD and McDonald's Corp. MCD. As has been recently noted, XLY is home to several of last year's best Dow stocks, including Home Depot, McDonald's and Nike Inc. NKE. 

Not surprisingly, investors are now faced with the specter of paying up for the privilege of getting involved with XLY and its high-flying components.

The S&P 500 currently trades at 17.4 times earnings, but the multiple on XLY is north of 21, according to State Street data. However, it can be argued that XLY warrants the higher multiple because it is home to some industry groups with robust earnings growth expectations.

"In terms of year-over-year earnings growth, six of the thirteen retail sub-industries in the S&P 500 are predicted to report growth in earnings for the fourth quarter, led by the Internet Retail (52.1 percent), Drug Retail (20.8 percent), and Home Improvement Retail (9.6 percent) sub-industries. On the other hand, seven of the thirteen retail sub-industries in the S&P 500 are predicted to report declines in earnings, led by the Home Furnishing Retail (-14.0 percent) and Hypermarkets & Super Centers (-9.0 percent) sub-industries," according to a FactSet note.

Although XLY and rival ETFs were solid performers last year, concerns exist about the ability of discretionary ETFs to repeat those showings in 2016.

“Firms in the sector have become leaner in the years since the financial crisis, although we question the big uptick in margins implied by consensus estimates for 2016, especially as savings at the gas pump aren't being spent elsewhere. Valuation multiples have traded in a fairly narrow range for the last two years -- see the P/E ratio -- but the sector remains richly valued versus the S&P500 in our opinion,” said AltaVista Research in a new note. 

To put it delicately, AltaVista's view on XLY is not encouraging. The research firm as an underweight rating on the largest discretionary ETF, which implies “funds in this category consist of stocks trading at relatively expensive valuations and/or having below-average fundamentals.”

According to AltaVista data, just 12 percent of XLY's shares outstanding are currently on loan to short sellers and the ETF's shares outstanding tally jumped 11 percent last year.