David Fabian: The S&P 500 Index was nearly unchanged in the first half of 2015, yet the divergences in underlying sectors told a very different tale. The tepid return in the major averages was generated by weakening in interest rate sensitive areas and continued strength in high growth leadership categories. This tug-of-war style market has created a relative valuation chasm between several important sectors that warrants close attention.
Leader: Health Care
Health care stocks were once considered a defensive area of the market similar to consumer staples and utilities because of their inelastic business models. After all, medical services and drug companies operate with little cyclical burden to their bottom line. Nevertheless, some believe that these stocks have transitioned to a more growth-oriented phase that has been driven by the biotech boom and continued advancements in the medical field.
The Health Care Select Sector SDPR ETF (XLV) has been a top performing area of the market over the last 3 and 5-year time frames and continues to lead as the number one sector so far this year. There is no doubt that this ETF has shown tremendous momentum and activity has been robust as XLV has gained 9.51% through June 30.
While this area of the market has been one of the most resilient, I would be hesitant to chase performance and add near its recent highs. If XLV or a similar health care fund has been on your radar, I would be patient with respect to any future entry points and look to pick up shares on at least a modest dip.
In addition, this sector should serve as a benchmark of momentum leadership. If we see XLV start to fall out of favor, it may signal that investors are looking to pair back on risk and potentially rotate into a more defensive stance. Health care stocks currently make up over 30% of the iShares MSCI USA Momentum Factor ETF (MTUM), which screens its underlying holdings for recent performance characteristics.
On the flip side of the coin, utilities have been torched this year as a result of rising interest rates. Coming off a strong performance in 2014 where rising rates acted as a tailwind, the Utility Select Sector SPDR (XLU) is down 10.70% through the first half of 2015. The price of XLU peaked at virtually the same time as interest rates bottomed and has been on a steady course lower ever since.
For the moment, it appears that the fate of utility stocks is going to be closely tied to the price action of U.S. Treasury yields. This traditionally defensive sector has been eschewed for more growth-oriented positions in health care, consumer discretionary, and technology stocks.
From a relative value standpoint, I believe that utilities look attractive at these levels given the thesis that interest rates will remain stable or head lower over the next six months. The recent drop in price has also boosted the yield on XLU to a healthy 3.80%, which makes it the highest yielding sector in the S&P 500.
Income investors should note that diversified dividend funds such as the iShares Select Dividend ETF (DVY) and First Trust Morningstar Dividend Leaders Index Fund (FDL) have outsized utility sector exposure. This asset allocation acted as a drag on returns in the first half of the year and should be noted as a key driver moving forward as well.
Financial stocks have long been touted as the cure to beat rising interest rates, yet the Financial Select Sector SPDR (XLF) has been mired in a sideways malaise since the beginning of the year. XLF posted a net return of -0.61% through the first six months of 2015 and has failed to show inspiring price action to back up its reputation.
XLF is an interesting fund because of the wide designation of financial-centric companies. This ETF includes large banks, REITs, brokerages, and even diversified holding companies such as Berkshire Hathaway Inc (BRK/B).