2023-07-13 07:05:55 ET
Summary
- The article evaluates the SPDR S&P Retail ETF as an investment option, which aims to correspond to the total return performance of the S&P Retail Select Industry Index.
- Despite performing well in isolation, the fund has lagged behind the S&P 500 due to the strong performance of the index's top holdings.
- I advise caution when approaching this fund, citing limited chances of strong gains or "alpha".
Main Thesis & Background
The purpose of this article is to evaluate the SPDR S&P Retail ETF ( XRT ) as an investment option at its current market price. The fund's objective is "to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P Retail Select Industry Index."
Retail - and XRT by extension - was an area I was bullish on heading in to Q2 this year. Looking back, this was a reasonable call. XRT has performed well in isolation since that buy call , but the fact is it has lagged the S&P 500, which has been rising due to strong performance by that index's top holdings:
Fund Performance (Seeking Alpha)
While XRT has "under-performed" I still find a gain near 10% in just over one quarter a darn good return. The fund has clearly seen a boost as this was a beaten down sector, inflation has started to ease, and the pace of Fed rate hikes has moderated. While there could be an argument for continuing to buy here, such strong short-term returns generally make me cautious. I see a cloudening picture for retail going forward and believe a downgrade to "hold" is the appropriate disposition here. I will explain why in detail below.
XRT Had Been In A Bear Market, That Is No Longer The Case
The primary point I want to emphasize is that I see sectors like retail as targeted plays. What I mean is, this is not a "set and forget" investment approach. Retail is generally more volatile than the market so picking the right spots is of heightened importance. Back in March, I noted that retail was in bear market territory and that a 20% drop in any sector - retail or otherwise - generally gets me interested. As the returns since then show us, this was the right call.
But fast forward to today and this is no longer a "beaten down" sector. For the year, XRT is up by double-digits as it has been propelled by the broader market rally:
YTD Returns (Google Finance)
Of course, this is not bad news. This is desirable performance and an argument could be made to continue on the momentum side of things. I wouldn't fault anyone for not wanting to trigger tax gains and miss out on more upside in a rising market. There are risks to that strategy.
But I am writing this with the mindset of do we want to put new money in at these levels. My opinion is no. XRT is no longer an unloved, out of favor play and these returns are not likely to be replicated in the second half of the year. Could they be? Of course - and I am more than willing to admit I am wrong if that turns out to be the case. But I tend to favor a contrarian approach to sector investing. Whether it is retail, energy, or utilities, I buy in to these sectors for diversification for my portfolio. But I only do so when they have fallen out of favor. Retail is back in favor - and that tells me we can enjoy the ride with existing positions but to be careful with new ones. That supports my "hold" rating at the moment.
Higher Interest Rates Pressure Consumers
The big story of this week (so far) is inflation. With June figures falling by more than forecasted, investors have taken this as a bullish signal. And I don't disagree with that assessment. Inflation is still high on a historical level, but it has come down sharply from the levels we have seen over the past year. This should give consumers and households some modest relief going forward:
Consumer Price Index (YOY Change) (Bureau of Labor Statistics)
On first glance this is a positive for retail. With inflation coming down, consumers can theoretically buy more goods (they can, but will they, is the question). And indeed this was how investors have been reacting as XRT is up in the short-term on the realization that inflation has been easing.
But I have concerns to this thesis. One, the gains for this fund suggest some of the positivity is getting baked in and that means less upside ahead if expectations do not come to fruition. Two, investors are taking a slowdown of CPI to mean that the Fed will also pump the brakes. While that is a very real possibility, the Fed's drop plot suggests another hike is on the way and that rates will stay elevated (historically speaking) for another year:
Fed Dot Plot (Federal Reserve)
This is not meant to be alarmist. I say this often in my articles because I don't want to be of the opinion that just because I don't want to buy something right now that doesn't automatically equate to proclaiming a fund/stock/sector is going to suddenly plummet. And the Dot Plot does suggest that in the years to come borrowing costs are going to ease - that is good for businesses and American households.
But this graphic also shows that borrowing costs are not going to drop substantially in the near term. This means that American consumers and borrowers are going to have to pay more to service debt and could stifle spending on discretionary items. This would hurt retail and it probably already is. Essentially, each dollar that is going to debt service is one dollar that can't be saved and/or used to buy goods. That transfers dollars from retail outlets to lenders.
And this is not some unjustified thesis. Credit card balances that are in arrears have been ticking up, as shown below:
Outstanding Credit Card Balances (Lending Tree)
This means two things. One, Americans are starting to rack up interest and borrowing expenses that are directly correlated with the Fed's interest rate hike cycle. Two, as Americans struggle with affordability (on average) for goods and services, demand is sure to slow. With this backdrop, it is hard for me to stay overly bullish on retail. This supports my downgrade for XRT.
Declining Car Prices Are A Headwind
Another reason for caution has to do with the underlying holdings in this particular XRT. This is a diversified fund - which is actually something I like about it. But it still is important to realize that the car/automotive industry remains an overweight area in this ETF:
XRT Sector Breakdown (State Street)
Generally speaking, I think this is reasonable exposure for the long-term for two reasons. One, I think this helps investors capture excess profits when used and new car prices rise as has been the case in the past couple of years. Two, it is an area that is mostly absent from the S&P 500. This means investors are getting a decent diversification benefit from this exposure which helps with overall portfolio management.
The challenge here is that used car prices are starting to ease. They are well down from a year ago and dropped in June on a month-over-month basis:
Used Car Prices (US National Average) (St. Louis Fed)
This will put some pressure on companies that rely on selling used cars as their inventory is suddenly worth less than it was last month. This is relevant to XRT because companies that sell cars are some of the top holdings. Case in point is Carvana ( CVNA ), which is actually the top individual stock:
XRT's Top Holdings (State Street)
The takeaway for me is that if this becomes the new trend then XRT's top holdings are going to have a hard time hitting higher levels. With that reality I see the prudent move as either taking some profits at this level or holding off for a better entry point going forward.
Savings Rates Have Dropped As Stimulus Evaporated
My final thought is about the state of American households with respect to savings. This has been a leading drive of gains to the retail sector in 2020 and 2021, which was a bit of a surprise considering the pandemic and the lockdown effects. But counter to the challenges, consumers were flush with cash due to stimulus checks and a lack of spending on travel and other entertainment. This gave consumers plenty of excess cash to spend online on goods, which propelled retail stocks to fresh highs.
Fast forward to today and that backdrop has changed dramatically. Stimulus checks have dried up and savings rates have normalized. In fact, they are lower than pre-pandemic. This is probably due to the impact of inflation:
Personal Savings Rate (US) (National Retail Federation)
This lack of a savings cushion is a firm headwind for the retail sector (along with other areas). This metric could tick up if the labor market stays hot and inflation continues its month-over-month decline. But we don't know if that will happen. For now it is reasonable to expect the macro-environment will keep savings rates depressed and that is not a positive for XRT.
Bottom-line
XRT is having a good year and momentum is clearly on its side. This makes a bullish thesis possible, but I have concerns. Inflation is moderating, but it is still high. Saving rates remain lower than pre-Covid levels and the Fed is expected to keep interest rates higher for longer. This will mean a pinch for American households as they spend more to service credit card debt and other interest expenses. Finally, XRT has a decent amount of auto-seller exposure and car prices are currently in decline. All of these factors support a rating downgrade for the fund at this time. As a result, I would suggest my followers approach any new positions carefully at this time.
For further details see:
XRT: Why I See An Argument For Taking The Profit In The Retail Sector (Rating Downgrade)