CPRI - I Won't Buy XLY Now As Mediocre Performance Expected

2023-06-27 06:45:00 ET

Summary

• Amazon and Tesla are the top two holdings of XLY, but they are both heavily invested in technology sector.
• The consumer discretionary sector outlook is still gloomy as consumers' purchasing power dropped, and their sentiment remained low.
• Most holdings of XLY are fairly valued, and will be fundamentally challenged during a recession.

I expect consumer Discretionary Select Sector SPDR® Fund ETF (XLY) to deliver mediocre return for the second half of 2023.

XLY is not a great pick as:

• Macro backdrop does not favour the consumer discretionary sector.
• Amazon (AMZN) and Tesla (TSLA) dominated the ETF.
• Constituents of XLY are close to fair value now.

XLY is a decent choice to give your portfolio exposure to the consumer discretionary sector, especially when you are unfamiliar with this sector. But indeed, it is not as consumer discretionary as you might think. Here are the top 10 holdings of XLY (as of 25 Jun) , which account for around 71.8% of the ETF.

Amazon and Tesla have significant exposure to technology. Amazon Web Services was accountable for 14% of total revenue in 2022 and was becoming a more important sector to Amazon. While Tesla designs and develops electric vehicles and supercharger stations. Due to their mega market cap, these two alone contributed over 40% of holding allocation.

Sector Outlook

Consumer Sentiment

The University of Michigan Consumer Sentiment Index measures the willingness of U.S. consumers to spend. According to the University of Michigan, Survey Research Center , the surveys employ a simple random sample selected from a list of all possible cell telephone numbers in the 48 coterminous States and the District of Columbia to yield a sample that is nationally representative (quote in Italic) .

The Index improved by 7.9% and 27.8% from May 2023 and June 2022, respectively, which shows possible signs for the retail sector to revive after severely affected by inflationary pressure and supply chain issues.

However, the overall expectations are still gloomy. Majority of respondents still thought it was not a good time to purchase a vehicle or house . The result shows that consumer expectation underwhelms. Respondents were also pessimistic about the business conditions and buying conditions over the next twelve months.

Retail Sales

Both U.S. retail sales and the Johnson Redbook Index show a significant slowdown in consumer activity growth in the first half of 2023, which hinted that a flat to low single-digit revenue growth is likely.

Individual stocks in the Top 10 holdings of XLY also recorded disappointing performance. In the latest financial quarter, Home Depot (HD) recorded a 4.5% decline in comparable sales, while Lowe's (LOW) also dropped 4.3%.

Labour Market

The US average hourly earnings averaged 4.38% in the first five months of 2023. However, despite softening inflation data, core CPI in May 2023 still stood at 5.3%, meaning consumers' purchasing power is depleted.

Unemployment rate was also the highest in 2023, which rose to 3.7% in May. But nonfarm payroll still displayed robust growth.

The Big Two of XLY

As Amazon and Tesla are two major constituents of XLY, which are accountable for almost half of the holding allocation, their recent performance will impact XLY forcefully.

Amazon

Amazon underperformed the market by a wide margin in 2022.

The retail and tech giant destroyed many small businesses as the company stepped into various spaces. But 2022 proved that itself is not indestructible. Due to inflationary pressure and supply chain issues, the company recorded a loss in earnings for two consecutive quarters (FQ1 and FQ2 2022). The diluted EPS of Amazon in FY2022 is -$0.27, which was the first negative earnings since FY2014.

While other members of FAANG also recorded a decline in earnings, they are still above the pre-pandemic level.

As Will Danoff , the fund manager of Fidelity Contrafund, said, " Stocks follow earnings. " Such fluctuations in earnings also led to the wavering stock price, leading its performance to lag behind other tech giants.

But shares picked up by presenting a ferocious comeback in 2023, up over 50% YTD, leading the stock to a forward PE ratio of 82.67. The stock is obviously not a bargain unless the company accomplishes hypergrowth in the coming years.

However, Amazon is a maturing business as its revenue growth slowed in recent years, especially since revenue from its online store business segment stayed flat last year.

Tesla

Tesla is not a buy to me, either.

Out of 25 SA authors, 6 made a bullish rating, 12 rated hold, and 7 gave a bearish rating in the last 30 days.

The average price target of TSLA over the next twelve months is also about 20% lower than the current price.

In response to the EV price war, the company announced a price cut on all its models, diminishing its profit margin. Tesla still owns a comparative advantage over its major competitors. But after recent rounds of price cuts, its gross margin dropped to 19.3%, while automotive gross margin is around 20%.

The cyclical nature of the auto industry is also another reason I wish to avoid this stock. As Elon Musk explained in the latest conference call, the high interest rate environment and uncertain economic backdrop are halting consumers from purchasing new cars. And U.S. Bureau of Economic Analysis data also showed auto sales plummeted in the previous recessions.

Conclusion

Home Depot and Lowe's experienced one of the worst performances in recent years as escalating mortgage rates adversely affected the housing market. As mentioned, both companies recorded negative comp sales in the latest financial quarter.

The Conference Board US Leading Indicator signals a recession within the next twelve months.

Other top 10 holdings in XLY, like O'Reilly (ORLY), Booking Holdings (BKNG), Nike ( NKE ) and TJX Companies ( TJX ) are very sensitive to economic cycles. Their earnings will decline as people likely lose their jobs, and disposable personal income will dive accordingly in my opinion.

The lack of spending incentives usually leads to a gradual shift in consumption behaviour. For instance, Dollar General (DG) found consumers less interested in discretionary segments.

Valuation for major constituents of XLY is also unattractive. Most of their forward PE ratios are less than 10% under their 5-year average forward PE ratio.

With all the above considered, instead of buying Consumer Discretionary Select Sector SPDR® Fund ETF, I would prefer picking individual stocks in this sector.

In my upcoming articles, I will explain why Capri Holdings ( CPRI ) and Floor & Decor ( FND ) are two better picks in the consumer discretionary sector. Stay tuned.

Please feel free to leave a comment below to share your view. Thanks for reading.

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