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By Robert Goldsborough

Since the start of the year, the United States equity sector that has underperformed the most has been the consumer discretionary sector.

While the U.S. stock market's performance has been slightly better than flat for the year, consumer discretionary names have been battered during the past three months. The weakness has come across many different consumer discretionary subsectors, including media, online retail, and traditional retail. In the wake of a very weak holiday shopping season in December--the worst holiday season for retail since 2009--and lousy weather trends that kept many shoppers home both in December and throughout winter 2014, many retailers have suffered. In addition, online retailer Amazon.com (NASDAQ:AMZN) and some media companies have lagged.

This pullback comes after a very impressive run. During the bull market, the consumer discretionary sector has been the single best-performing U.S. equity sector during the past five years and the second-best performer over the past three years. As investors survey a fairly-valued U.S. equity landscape and seek places to invest, an exchange-traded fund devoted to consumer discretionary companies can make a lot of sense. Large ETFs offer investors exposure to both the titans in the industry and to the relatively small players as well. And in an ETF, an investor can gain the best of both worlds--upside from stronger consumer confidence and consumer spending, along with protection from exposure to any one company or subsector within the consumer discretionary space.

As my colleague Ben Johnson highlighted in his article last week, Morningstar's fair value estimate for ETFs is a helpful way to quickly give investors an aggregate, asset-weighted fair value estimate of the stocks in an ETF's portfolio that are covered by Morningstar equity analysts. And with its recent pullback, the consumer discretionary sector is, according to our fair value estimate, more attractively priced on a relative valuation basis than any U.S. equity sector, other than the energy sector.

The Lay of the Land
Before going further, let's define the parameters of the consumer discretionary industry. Across the consumer discretionary sector, the biggest subsector is retail. That means everyone from titans such as Home Depot (NYSE:HD) and CVS Caremark (NYSE:CVS) to relative pipsqueaks like Aeropostale (NYSE:ARO), Vitamin Shoppe (NYSE:VSI), and Express (NYSE:EXPR) can be found in retail ETFs. Online retailers, such as Amazon and eBay (NASDAQ:EBAY), are there as well. (Retailers deemed as non-discretionary, such as Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR), are only found in some ETFs.)

Next is the media subsector, which includes large cable and satellite companies such as Comcast (NASDAQ:CMCSA) and DirecTV (NASDAQ:DTV) and TV station owners and content companies such as CBS (NYSE:CBS), Twenty-First Century Fox (NASDAQ:FOXA), and Walt Disney (NYSE:DIS). Other meaningful parts of the sector are restaurant, hotel, and casino operators such as McDonald's (NYSE:MCD), Yum Brands (NYSE:YUM), Hyatt (NYSE:H), and Wynn Resorts (NASDAQ:WYNN). Automakers, automotive retailers, and auto components makers also are found in some but not all consumer discretionary ETFs, based on the indexes that they track.

What's Going On Right Now
Consumer confidence in the U.S. has been on the rise and in March 2014 unexpectedly hit its highest level in more than six years, according to data from The Conference Board, which is an industry group. Clearly, consumers are feeling more bullish about the job and housing markets--as well as about the weather, after a brutal winter. This reading is a positive sign about increased consumer spending. It also comes after some weaker readings in the fall and winter but generally positive readings in earlier 2013 that also were recent highs. In the medium term, there are plenty of reasons to be bullish on consumer confidence, including a stock market near record highs, a rebounding housing market, and a very slowly improving job market. Morningstar's director of economic analysis Robert Johnson forecasts gross domestic product growth of 2.0% to 2.5% in 2014, with employment growth of 190,000 jobs per month and inflation at 1.5% to 1.8%. He also anticipates consumer spending that is stable to modestly higher.

Despite rising consumer confidence, many traditional bricks-and-mortar retailers have suffered in recent months from the aforementioned lousy holiday season and cold weather. Even the stock prices of online retailers have struggled. Amazon shares have been pressured after the company missed earnings by a meaningful amount in early 2014, some investors became anxious over the expected (and recently announced) price increase for Amazon Prime, and some investors had what we consider to be overblown concerns about potential competition with Alibaba. There also was some general profit taking and rotation out of the name by momentum investors. And some media companies have struggled of late amid technological and product changes ahead, including Comcast's bid for Time Warner Cable (NYSE:TWC), rumors of Apple (NASDAQ:AAPL) and Comcast joining forces to create a possible joint video-streaming service, and higher costs.

Because of these recent headwinds, the consumer discretionary sector is relatively undervalued right now, according to Morningstar's equity analysts. It strikes us that some fairly short-term dynamics are pressuring a good number of consumer discretionary names, and we could see a number of those reversing (or at least ceasing to be drags) as 2014 progresses. For the sector to outperform in the medium term, we would expect to see further gains in the housing and job markets, with real wage growth. In addition, the global stage would need to take part as well, with rebounding strength in Europe and, in particular, emerging markets. (We like the idea of a growing base of middle-class consumers in emerging markets helping to offset broader economic concerns over the long run.) With those factors in place, we could see the consumer discretionary sector resuming its rally.

ETFs Devoted to the Consumer Discretionary Industry
There are two large ETFs focused on the U.S. consumer discretionary industry. Vanguard Consumer Discretionary ETF (NYSEARCA:VCR) charges a very low 0.14% expense ratio. VCR, which tracks a market-cap-weighted index, holds 374 companies and devotes about one-third of its assets to retail, with another 27% invested in media and entertainment companies. The fund historically has been more volatile than the broader market, with an 18.5% volatility of return during the past five years compared with 14.3% for the S&P 500 Index. Another large consumer discretionary ETF, which is even larger and more liquid than VCR, is Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY). It costs 0.16%. Also market-cap-weighted, XLY holds a much more concentrated portfolio of just 84 companies and has relatively similar subsector weightings as VCR. XLY has displayed slightly less volatility than VCR during the past five years, posting a 17.7% volatility of return.

A global consumer discretionary ETF option is iShares Global Consumer Discretionary ETF (NYSEARCA:RXI), which charges 0.48%. However, investors should note that with RXI, they are essentially getting overweight exposure to the automotive industry, given that RXI's top-10 holdings include Toyota (NYSE:TM), Ford (NYSE:F), Daimler, and Honda (NYSE:HMC). And auto manufacturers, auto retailers, and auto components together make up more than twice the position that they comprise in VCR and XLY.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Consumer Discretionary Stocks: The Winter Of Discontent