Late last week, Gradient Investments investment analyst Mariann Montagne came out and said something many other observers are thinking, but are too afraid to say in fear of being ostracized. She simply said it was time to lock in gains on some of this year’s better-performing sectors, as they’d reached alarming valuations.
For Montagne and Gradient, that mostly meant REITs, which are up big-time this year. She also explicitly mentioned utilities as another dangerously frothy sector though, which is sporting price-to-earnings ratios near 20-year highs. Conversely, Montagne also noted higher-volatility stocks as a better place to be, including technology and financial stocks, which have mostly underperformed the broad market year-to-date.
While her point was well taken, it may have also been understated. The divergence between the market’s top performers and laggards has been especially wide over the course of the year so far, and it’s becoming clear roles are starting to reverse in a big way now that valuations are once again starting to mean something.
The performance comparison of all the major sector exchange-traded funds of the iShares family tells the tale. The iShares Dow Jones US Utilities ETF (NYSEARCA:IDU) is up most so far this year, with a 15% advance despite a pullback from its early July highs. The iShares Dow Jones US Financial ETF (NYSEARCA:IYF), conversely, is dragging the bottom with a year-to-date performance of 2%, though it has arguably been one of the better advancers since the February low.
A closer look at the performance comparison chart confirms something else though … things are changing. It’s not just REITs and utilities and financials in need of some scrutiny (for better or worse).
The reason all sector-based ETFs — as well as industry-based ETFs — need to be given a second look isn’t tough to pin down either. This year’s wild moves have pushed several P/E ratios to extremes, given past and projected earnings growth.
The table above compares current and forward-looking valuations, and growth rates. Some make sense. Some don’t. Some are outright implausible.
For perspective, the rule of thumb is, a stock or sector’s P/E ratio should match its earnings growth rate. In other words, is earnings are growing at an average pace of 12%, the “right” P/E ratio is around 12. If earnings are growing at a pace of 20%, then a P/E of 20 is justified.
Mental adjustments can and should be made for things like low interest rates or outlier results. Still, many of the above numbers more than push their valuation boundaries.
With that as the backdrop, here’s a look at the top three ETFs to sell now, and the top three ETFs to scoop up.
3 ETFs to Buy
Investors have spent the last several months assuming interest rates would not only stagnate, but even sink. As a result, IYF is the worst-performing sector in the bunch, since most financial stocks see thinner profit margins in low-rate environments.
Big mistake. Though they’re sure to be choppy going forward, a rate hike is on the horizon sooner or later. IYF doesn’t have much more downside to dish out.
Now would also be an ideal time to add the iShares Dow Jones US Consumer Services ETF (NYSEARCA:IYC) to portfolios.
It’s most akin to the S&P 500 Discretionary Sector, which doesn’t look cheap with a trailing P/E of 19.2. This group has been one of the better, and more consistent, earnings growers though. IYC has been a laggard on the performance chart but is picking up steam.
Last but not least, the iShares Dow Jones US Technology ETF (NYSEARCA:IYW) offers a nice mix of new momentum and respectable value.
3 ETFs to Take Profits On
While Mariann Montagne only used it as an example, she was onto something when she used the utility sector as an example of an overinflated group. The IDU as well as the S&P 500 Utilities Index are both approaching a trailing P/E near 20, and dividend yields aren’t that great anymore.
It may also be a good idea to go ahead and pull the plug on the iShares Dow Jones US Healthcare ETF (NYSEARCA:IYH). Its projected earnings growth rate of 32.7% may look juicy compared to other ETFs, but analysts have been looking for that kind of growth for year now. They’ve yet to see it. Single-digit growth has been and will continue to be the norm, especially now that the full impact of the Affordable Care Act is taking a toll.
Finally, though one has to be sympathetic to the sector, the iShares Dow Jones US Basic Materials ETF (NYSEARCA:IYM) is going to struggle for a long while justifying its current value … turnaround or not.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.