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In 2011, S&P 500 profits expanded 15%. And yet, the benchmark’s price finished in the very same place that it started the year. In essence, since prices flat-lined and earnings experienced double-digit growth, a fundamentally inexpensive stock market via the price-to-earnings ratio (P/E) became even cheaper.

The most common reason cited for P/E contraction in 2011? The eurozone debt crisis.

Obviously, sovereign debt concerns have not disappeared in 2012. That said, will its impact be as dramatic over the current 12 months as it was in the prior 12 months? Maybe not.

Let’s consider the possibility that investors are beginning to feel that Europe’s “situation” is already being discounted by the markets. In this scenario, we would likely experience P/E reversals. That is, the S&P 500 and its individual economic sectors could conceivably revert back to the P/Es that existed on 1/1/2011.

Using the S&P 500 as a guide, current estimates for profit growth in 2012 are for a less robust 10.2% earnings expansion. If the S&P 500 reverts back to its P/E ratio price tag from the start of 2011 - with 10.2% profit growth in 2012, 15% growth in 2011, and 0% price gain in 2011 – one might expect a 25.2% gain for the S&P 500.

Is a 25.2% gain for the S&P 500 reasonable? Perhaps.

If the S&P 500 logs a 25.2% gain in 2012, it will reach 1573 – smack near the October 2007 all-time highs. On the surface, hitting or reaching the October 2007 highs may sound like a big deal. However, the December 2012 P/E would be far lower than the October 2007 P/E ... still making stocks much cheaper than they were five years earlier.

Of course, these numbers are for the S&P 500 as a whole. What if we applied the same P/E reversal thinking to the nine S&P Sector Select SPDR ETFs? What might a respective sector ETF gain (or lose) by the end of 2012, if we make the same assumptions about reverting to the price-to-earnings ratio of 1/1/2011.

Sector ETF Expectations If P/Es Revert To 1/1/2011
P/E Growth Profit Growth Potential
(Contract) (Expect 2012) Return ‘12)
Utilities Select Sector SPDR (NYSEARCA:XLU) 14.6% 0.0% -14.6%
Consumer Staples Select SPDR (NYSEARCA:XLP) 7.4% 8.4% 1.0%
Health Care Select Sector SPDR (NYSEARCA:XLV) 7.1% 11.3% 4.2%
Consumer Discretion Select SPDR (NYSEARCA:XLY) -3.4% 10.5% 13.9%
Technology Select Sector SPDR (NYSEARCA:XLK) -9.6% 13.9% 23.5%
Energy Select Sector SPDR (NYSEARCA:XLE) -23.5% 2.3% 25.8%
Industrials Select Sector SPDR (NYSEARCA:XLI) -14.9% 13.6% 28.5%
Financials Select Sector SPDR (NYSEARCA:XLF) -21.8% 12.7% 34.5%
Materials Select Sector SPDR (NYSEARCA:XLB) -32.9% 8.6% 41.5%
S&P 500 -15.0% 10.2% 25.2%

Notice that each of the 20%-plus returns come from the economically sensitive cyclical segments - materials (XLB), energy (XLE), technology (XLK), financials (XLF) and industrials (XLI). Intuitively, this is not difficult to comprehend. The 2011 leaders came from the defensive segments, like healthcare, staples and utilities.

It follows that the only realistic shot for P/E reversion to occur in 2012 is for the global economy to find itself in increasingly better shape by the end of the year. If China begins to stimulate its economy through monetary and fiscal easing, if Europe gets beyond the notion of multiple eurozone defaults, and if the U.S. can continue to make muddle-through strides in the right direction, we may indeed get the super-sized gains out of the cyclical sector ETFs.

Is 41% out of SPDR Select Materials (XLB) realistic? It has already claimed 9% out of the 2012 gates, better than the other segments. Ironically enough, XLB registered 43% in 2009.

On the other hand, the P/E ratio hardly represents an exact science. For example, utilities may be slightly overvalued, but we have entered a period where yield may be every bit as important to the investor as capital appreciation. A slow-growth sector doesn’t necessarily have to fall -14.6% because its multiple is a bit higher than the historical average; rather, the earnings yield of 6.85% and dividend yield of 3.85% may be the perfect risk-reward scenario for conservative investors who want more from money markets or paltry treasury yields.

Keep in mind, I am not recommending that one make a whole-scale shift out of defensive equities and into cyclical sectors like energy (XLE) or technology (XLB). In fact, I have plenty of income-oriented positions from diversified high yield to MLPs to dividend producers. Indeed, I still expect faith-shattering volatility in the first half of 2012. By the same token, it’s important to point out that P/E reversion is a distinct possibility and that ... if it happens ... higher-beta, riskier sectors may thrive.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Source: P/E Reversals May Identify Sector ETFs With The Most Promise In 2012