These Sector ETFs Are Starting to Look Overvalued

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August 29, 2016 10:52am NYSE:VDC

From Zacks: Thanks to global growth slowdown, hard landing fears in China, uncertainty over the Fed rate hike, the yet-unseen impact of Brexit and oil price volatility, safe-haven assets and the defensive sectors had a great show this year.

But the tables are turning lately with stocks hitting highs as Brexit-fears look overestimated (at least as of now), several U.S. economic readings coming in better including the all-important job market and several Fed officials viewing the economy as healthy enough to digest a Fed rate hike this year (read: 3 ETF Ways to Win if the Fed Acts in September).

Agreed, the GDP growth data for Q2 lacked luster at 1.1%. But a solid job market and the economy getting closer to ‘stable prices’ are strong positives. Fed chief Janet Yellen indicated that the U.S. economy is moving slowly toward the central bank’s targets, which in turn bolstered chances of a rate hike in the coming days.

Meanwhile, stocks have seen an impressive start to Q3 as the key U.S. indices are hitting highs every now and then. While this spread cheer among equity investors, overvaluation concerns might bring crinkles on their forehead (read:Believe in George Soros? Short S&P 500 with These ETFs).

Should You Play Overvalued Sector ETFs Now?

This double-edged scenario raised questions on whether investors should practice overvalued sector ETFs now. As per the Earnings Trends issued on August 24, 2016, Consumer Staples is the third overvalued sector among the 16 sectors within the S&P 500, classified under the Zacks methodology.

Consumer Staples – Forward P/E 23.1 Current Year

The sector boasts a current year P/E of 23.1 and the next year P/E of 20.9. This is way higher than the S&P 500 forward P/E of 19.4 for the current year and 17.1 for the next.

With the Fed rate hike bets for this year rising lately, investors may now dump this defensive as well as overvalued sector ETF. Treasury bond yields have started rising since Fed Chief Janet Yellen’s Jackson Hole meeting, which will mar the sector’s relatively higher yields.

For example, Vanguard Consumer Staples ETF (NYSE:VDC) yields about 3.34% annually with a P/E ratio of 25 times. But given the present circumstances, this higher valuation may go against the fund. VDC lost about 1% in the last five trading days (as of August 26, 2016) (read: A Guide to Consumer Staples ETF Investing).

Utilities – Forward P/E 18.2 Current Year

This sector has a current year P/E of 18.2 and the next year P/E of 17.8. Though the P/E is lower than that of the S&P 500 for the current year, it is above a few others. Plus, P/E for the next year is higher than the S&P 500 (read: ETFs to Watch as Fed Members Indicate Rate Hike in September).

For example, iShares Dow Jones US Utilities ETF (NYSE:IDU) yields about 3.51% annually and has a P/E of 21.4 times. But investors should note that the sector has added over 19% so far this year (as of August 24, 2016). And now with the rate sensitive and high-yielding sectors likely to take a backseat, investors may see steep sell-offs in the utility ETFs, which are also fraught with overvaluation concerns. IDU lost about 2.3% in the last five days (as of August 26, 2016).

Construction – Forward P/E 20.9 Current Year

The sector boasts a current year P/E of 20.9 and the next year P/E of 17.7. The sector is up 18.6% so far this year (as of August 24, 2016) compared with 9.7% gains in the S&P 500. Now the construction sector also depends on borrowings for operations and may thus underperform in a rising rate environment.

So, even for this space, overvaluation issues and bets over rising rates come as unfavorable news. The PowerShares Dynamic Bldg. & Const. ETF (NYSE:PKB) gained about 0.5% in the last five trading days but was down about 1.2% on August 26, 2016.

This article is brought to you courtesy of Zacks Research.

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