Investment Outlook For The Sector SPDRs

Here's our current investment opinion for each of the nine Select Sector SPDRs:

Consumer Discretionary SPDR (XLY): We’re not bears on the U.S. consumer per se, but earnings estimates for XLY simply appear too optimistic to us, since they are predicated on a big increase in margins to levels never before achieved. Estimates are in free fall, yet XLY has the highest P/E of any sector – higher than even Technology!

Consumer Staples SPDR (XLP): Earnings for companies in XLP are forecast to grow faster than earnings for the S&P 500 this year which may make the sector a good defensive play, but XLP already trades at a premium to the market. Plus, the sector’s Return on Equity has been falling for years, which poses an additional threat to valuations given its high Price-to-Book Value multiple (there is a high correlation between ROE and P/BV, so falling ROE could mean lower P/BV multiples in the future).

Energy SPDR (XLE): Earnings are expected to be down slightly this year, but with oil prices surging again that could prove pessimistic. At any rate, times are good for Energy companies and XLE, which trades at the lowest P/E of any Sector SPDR, may still offer good investment potential for serious long-term investors (5+ years) regardless of near-term fluctuations in oil prices, since by our analysis XLE is cheap relative to cycle average profitability.

Financials SPDR (XLF): Turmoil among sub-prime mortgage lenders does not as yet appear to have affected the earnings of the Financial sector overall. In fact, 2007 earnings estimates for XLF actually rose over the past month—the only sector that saw an increase. Our belief is that the large banks and brokers which dominate the sector will not see a spill-over effect, and in any case the boom in M&A activity which is bringing tremendous fees to Wall Street will more than compensate for any mortgage-related risk that was not sufficiently hedged. Therefore we think earnings estimates could actually prove conservative and at any rate EPS growth is currently forecast to be about as fast as for the S&P 500. Despite this, XLF trades at a substantial discount to the market on most valuation metrics.

Industrials SPDR (XLI): There could be upside to current EPS estimates given recent strength in export demand and this sector's relatively large foreign sales—which are more than a third of overall sales—and they also tend benefit from a weaker dollar. At any rate, current estimates still see faster earnings growth than the S&P 500 in 2007, but shares of XLI already trade at a slight premium to the market so are probably not a bargain.

Health Care SPDR (XLV): Upside potential for XLV, which already trades at a premium P/E to the S&P 500, seems limited: Health Care is the only sector for which EPS growth trailed sales growth over the past five years, due in part to persistent declines in Return on Equity. And the drug companies which dominate the index (about two-thirds of assets) are unlikely to get much help from headlines coming out of Washington given the Democrats' control of Congress.

Technology SPDR (XLK): Estimates have been falling and investors may have to wait until 2008 to see the kind of earnings growth that Tech is supposed to deliver. And as always valuation is a concern: XLK is trading at more than 19x current-year estimates.

Materials SPDR (XLB): Current consensus estimates imply that firms in XLB are at or near peak profitability and that earnings growth will be minimal in 2007, although that obviously depends on the future direction of commodity prices. XLB trades on par with the S&P 500, and is still considerably more expensive than another highly cyclical sector: Energy (XLE).

Utilities SPDR (XLU): Consensus earnings estimates suggest fundamentals remain solid, and XLU offers the highest dividend yield of any Select Sector SPDR. However, steady gains of more than 100% since early 2003 have resulted in higher multiples which, in turn, may depress returns going forward.