Market Overview

Sneaky High: Some Sector ETFs Now Surprisingly Pricey


Some sectors have a reputation for being home to value stocks, but that does not mean that those sectors are always a good value. With the risk on trade being emphatically turned off over the past three months, investors have predictably scurried away from high-beta sectors such as energy and materials to boring hideouts such as telecommunications and utilities.

The subsequent runs, higher by several popular conservative sector ETFs, has these funds looking a little frothy. As has been noted before, there are plenty of sector funds with elevated price/earnings ratio that would not surprise many investors.

Now, there are some sector ETFs with valuation surprises in store. Buyer beware.

Utilities Select Sector SPDR (NYSE: XLU) Over the past 90 days, the Utilities Select Sector SPDR is up 6.2 percent while the SPDR S&P 500 (NYSE: SPY) is off 4.4 %. Said differently, investors have flocked to utilities, a sector prized for its low correlations to high-beta sectors and the broader market.

XLU's current P/E ratio of almost 15.4 is towards the higher end of the historical average for high-quality utilities stocks, but the P/E ratio isn't the problem. At the end of May, XLU was sporting a price/earnings to growth ratio that was well in excess of SPY and the SPDRs funds tracking the financial services and technology sectors, just to name a pair.

XLU, with its yield of just under four percent, is sitting just pennies below its 52-week high, but some have grown skeptical of this bull run with one noted technical analyst issuing the bold proclamation that XLU could possibly fall to $20.

iShares Dow Jones U.S. Telecommunications Sector Index Fund (NYSE: IYZ) The iShares Dow Jones U.S. Telecommunications Sector Index Fund has been another prime beneficiary of the flight to boring sectors. In the past month, IYZ is up 6.1 %, a performance that is understandable when noting IYZ has a beta of just 0.66, according to iShares data.

IYZ does have a strong chart and it can be argued the fund does have more upside in store as it rests 11.2 % below its 52-week high. The cautionary tale comes in the form of a P/E ratio over 40. That is more than double the P/E ratio on the iShares Dow Jones U.S. Technology Sector Index Fund (NYSE: IYW), an ETF that allocates almost 23 % of its weight to Apple (Nasdaq: AAPL).

Consumer Staples Select Sector SPDR (NYSE: XLP) Investors continue to put cash to work with staples stocks and ETFs. That much is highlighted by the fact that for the week ending June 14, XLP saw inflows of $378 million, according to ETF Channel data.

With a current P/E ratio of just over 16, XLP is trading at the higher end of its trailing 12-month range, indicating this sector that is often viewed as the epitome of a value play may have little value left to offer.

First Trust Health Care AlphaDEX Fund (NYSE: FXH) A recent note by Goldman Sachs on the topic of sector correlations indicates that some investors may be caught off guard by the rising correlations shown by the Health Care Select Sector SPDR (NYSE: XLV).

"While 32 of the examined 36 sector pairs showed decreases in correlations, all of the four that showed increases included Healthcare. As an example, correlations between Healthcare and Financials rose to 76% from 73%, versus an average decrease in correlations of 8% among all 36 pairs," Goldman said in the note.

This is relevant to the First Trust Health Care AlphaDEX Fund as well. FXH, a $543.8 million ETF that has earned five-star ratings from Morningstar based on its three- and five-year performances, is a credible alternative to the larger XLV. Year-to-date, FXH has outperformed XLV by more than 400 basis points. That added alpha comes at a slight premium though as FXH now sports a P/E ratio of 13.8 compared to less than 12.5 for XLV. In defense of FXH, the ETF's price/book ratio is lower than XLV's.

For more on ETFs with elevated P/E ratios, click HERE.


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