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ETF Specialist

Four Sector ETFs to Consider Today

Some ETFs to think about if you believe the market is overextended.

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To even the most seasoned investors, the typical rules of investing have been shattered not only during the dramatic fall in the S&P but also in the most recent 50% rise off its low March 9. Much has been said about the speed and magnitude of the rise in the broad markets, and what I have found particularly interesting is how different sectors have performed during the past five months.

While the stock market cycle typically runs ahead of the economic cycle, sectors typically gain in an uneven pattern. Famed investor Peter Lynch stated, "If you are in the right sector at the right time, you can make a lot of money very fast."

To view the S&P 500's rise by sector, we decided to use the Select Sector SPDR ETFs, which slice and dice the index into nine sectors. Let's take a look at price performance (as of Aug. 21, 2009) since the March lows in these ETFs and see what it reveals.

  Price as of 3/9/2009 ($) Price as of 8/21/2009 ($) % Gain Materials Select Sector SPDR (XLB) 18.18 30.31 67 Health Care Select Sector SPDR (XLV) 21.88 28.68 31 Consumer Staples Sector SPDR (XLP) 19.41 24.74 27 Consumer Discretionary Sector SPDR (XLY) 16.11 26.32 63 Energy Select Sector SPDR (XLE) 38.86 52.35 35 Financial Select Sector SPDR (XLF) 6.26 14.55 132 Industrial Select Sector SPDR (XLI) 15.36 25.3 65 Technology Select Sector SPDR (XLK) 13.22 20.09 52 Utilities Select Sector SPDR (XLU) 22.74 29.72 31

Putting these data into historical perspective, some of the sectors are performing as one would expect. Financials and discretionary consumer stocks are typically the first to rise as the economy is hitting a trough. Defensive sectors like health care and consumer staples typically lag because their businesses are steadier and less leveraged to the economic cycle. While the technology SPDR is showing a similar rise compared with the broader market, the lack of a larger increase has a lot to do with the composition of the portfolio. The fund has significant weights in telecom giants  Verizon (VZ) and  AT&T (T). Much of technology has been on fire this year and has easily outperformed the broader market.

What has been a little atypical for the point we are in the economic cycle is the swift rise in industrial and materials stocks, which typically gain steam a little later on. However, S&P 500 constituents are much more global today than in the past, and China's continued economic expansion has been a significant positive for industrials and materials companies. The country's GDP grew 7.1% during the first half of 2009, partially driven by substantial gains in fixed-asset investment. The government's massive stimulus package and credit expansion have fueled the Chinese domestic economy, more than offsetting a significant decline in exports.

In our view, if you hold materials and industrials stocks, get waning demand from China, and anything less than a V-shaped recovery in developed markets, then watch out. There may be select industrial and materials stocks that are still attractively priced, but from a high-level sector perspective, the rally in industrials and materials stocks seems long in the tooth.

Let's say, for the sake of argument, that we are in the midst of a powerful economic recovery. If that's the case, history suggests the next sector to make a big jump should be energy. Energy underperformed the S&P during the recent rally; however, much of the underperformance can be chalked up to the disproportionate weighting of the large integrated oil producers in the index tracked by  Energy Select Sector SPDR (XLE).  ExxonMobil (XOM),  Chevron (CVX), and  Conoco Phillips (COP) account for about 40% of the index.

If we cut finer into the energy space, we see that many companies have indeed experienced considerable gains in their stock prices.  IShares Dow Jones US Oil & Gas Exploration & Production (IEO) and  iShares Dow Jones US Oil Equipment Index (IEZ) are up 58% and 66%, respectively, since March 9. Based on fair value estimates of the underlying constituents of these ETFs derived by our equity research team, many exploration and production companies may have more room to run while the bulk of the oil equipment and services names could be due for a pullback.

On the ETFs team, we have been fans of IEO for awhile. A surging economy will certainly propel this fund, but we think the long-term imbalance between supply of hydrocarbon-based energy and demands from growing economies will drive higher oil prices for many years to come.

After energy stocks attract increased interest, it's usually late in the bull market cycle for stocks and investors tend to rotate to defensive sectors like consumer staples and health care. If you needed any confirming evidence that the stock market has rallied much faster than the economic fundamentals would typically dictate, this is it. What this really says to me, though, is that as much as stocks may have been gaining on the prospects for economic recovery, this smells more like a bear-market rally. At some point, the economy has to validate what the stock market has done. As such, there appears to be much more downside risk than upside potential, at least in the near term.

Based on the economic data and sector performance since early March, the prudent approach seems to be to get defensive, with perhaps a sprinkling of energy. Large, high-quality health care and consumer staples firms haven't significantly participated in the market bounce. In addition, the ETFs in these sectors look cheap on a fundamental basis, as do some energy ETFs. Below, we have listed some sector ETFs that you may wish to look at to position your portfolio for a potential pullback in the broader market. While even Peter Lynch would likely agree that the choices below won't necessarily make you fast money, capital preservation can be a key part of building wealth over time.

 iShares Dow Jones US Oil & Gas Exploration & Production (IEO)
Unlike vertically integrated oil companies like ExxonMobil and Chevron, the companies held by this fund are almost entirely focused on the businesses of exploration and production of oil and natural gas, and their revenues are split almost equally between the two. Although we find it curious that oil refiner  Valero (VLO) is a holding, this fund has little exposure to midstream assets, such as refining, pipelines, and retail marketing. This gives the fund more leverage to oil and gas prices and less revenue diversification than oil- and gas-themed funds with sizable holdings of large integrated energy companies.

 iShares S&P Global Healthcare (IXJ)
IShares S&P Global Healthcare offers investors exposure to a portfolio of some of the finest health-care companies in the world. Similar to the overall health-care sector's industry breakdown, big pharma soaks up the lion's share (roughly two thirds) of this cap-weighted fund. Rounding out the portfolio is a sprinkling of managed-care firms, mature biotech companies, and medical device firms.

 iShares Dow Jones US Medical Devices (IHI)
Health-care needs aren't tied to the economic cycle, so demand for medical equipment tends to be steady. Furthermore, an aging population and fast-growing markets abroad have spurred demand for cardiovascular and orthopedic devices as well as patient care and diagnostic instruments. This, coupled with continued product innovation, should ensure that holdings such as  Medtronic (MDT) and  Stryker (SYK) continue to churn out double-digit cash-flow growth and returns on capital.

 Consumer Staples Select Sector SPDR (XLP)
This ETF, which offers exposure to mega-cap household names with which consumers continue to transact business regardless of the economic climate, could be viewed as a defensive tilt for a broad-based equity portfolio. Investors looking for explosive growth are better suited looking elsewhere, however, as this portfolio is chock-full of mature businesses offering relatively stable returns and an average market cap of about $42 billion.


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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Mitchell Corwin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.