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The Consumer Discretionary sector (XLY) is off to a solid start in 2012, up 15.4% compared to the 11.2% rise in the S&P 500. The 81 stocks in the S&P 500 that make up the sector include 29 names up more than 20%, while a dozen names have declined in price. The strong performance of the sector is nothing new, as it has been among the best performers over the past five years. Here is a look at the historical performance through 3/31/12, according to data from Standard & Poor's:

(click to enlarge)

The sector, which makes up about 11% of the S&P 500's market cap, is quite diverse. S&P breaks the sector into five different industry groups: Autos (6%), Consumer Durables & Apparel (11%), Consumer Services (18%), Media (28%) and Retailing (37%).

Six names in the group are quite large, each in excess of $50 billion in market cap and, in total, representing about 1/3 of the sector. With the exception of the largest, McDonald's (MCD), they are all up more than the S&P 500 in 2012:

  • McDonald's : -2%
  • Amazon (AMZN): +12%
  • Comcast (CMCSA): +25%
  • Home Depot (HD): +20%
  • Disney (DIS): +15%
  • Nike (NKE): +15%

Now some may look at a few of the best performers and conclude that the performance for the sector is being driven by a handful of names, but that is clearly not the case. There are 10 names up 30% or more, but they don't account for a great deal of the overall sector in terms of market cap:

  • Sears Holdings (SHLD): +96%
  • Fossil (FOSL): + 74%
  • Priceline.com (PCLN): +62%
  • Netflix (NFLX): +60%
  • Whirlpool (WHR): +59%
  • TripAdvisor (TGRIP): + 44%
  • Gap (GPS): + 43%
  • Lennar A (LEN): +34%
  • BorgWarner (BWA): + 32%
  • Pulte Group (PHM): +31%

After taking the beginning-of-the-year market caps, the contribution of the top 10 performers, which currently total $100 billion (the same as just MCD), was less than 3%. By my calculation, the other 71 names are up 13.3% in aggregate, more than 2% better than the S&P 500.

So, if it's not short-covering in a handful of beaten up names driving performance for the sector, what is it? I mentioned earlier that there are five industry groups, and three of them are not really driving the performance. The two that are? Retailers, which are up an average of 19.4%, and Consumer Durables & Apparel, which are up average of 26%.

If one looks at the names in these categories, there is a dominant theme: Domestic exposure. While there are certainly several strong performers that have international exposure, many, especially among the retailers, are focused domestically. With so much concern over the European economy, it's not surprising to see investors gravitate towards some of these names.

Retail sales have been surprisingly strong in the past few months. On March 13th, the government data for February came in above expectations, with the prior month revised higher. Same-store-sales figures for March released this past week were robust as well. I am somewhat cautious in the near-term, as good weather and an early Easter may have played a role.

As I look at the Consumer Discretionary sector, especially in the context of a market that is somewhat extended, I don't see too many big concerns. Consumer Confidence is improving, though still rather low. The last read of 70.2 in March was among the highest since the Great Recession began and well above the lows of 40.9 last October. After averaging 58.1 in 2011, 54.5 in 2010, 45.2 in 2009 and 40.7 in 2008, the current numbers are a sharp improvement, though this is the way we started 2011. It seems like a distant memory, but the average in 2005-2007 was above 100.

While some of the stocks are trading at valuations not seen for many years, I am not too concerned, as earnings are projected to accelerate next year. According to S&P, earnings for the sector are projected to rise by just 6% this year after increasing 14% last year. In 2013, the current expectations are for 17% growth. While this may prove too optimistic, it helps frame the 16PE for 2012 for the sector, as the premium to the S&P 500's 13.3PE may be justified by the higher 2013 projected growth for the sector. Still, the stocks don't stand out as particularly cheap.

The strong performance of the sector makes sense to me, but there are several names that look due for a pullback. I would like to highlight Home Depot and Lowe's (LOW) as well as TJX (TJX) and Ross Stores (ROST). These stocks are all up in excess of 20% YTD and are trading at PEs above 17X. From a technical perspective, two things concern me for each of them. First, they appear extended, with a failure in all cases to take out the 50dma over the past 13 weeks. In fact, it's been longer - these are very mature trends. Second, while it's not extreme, each of the names appears overbought to me (I use StockVal's "price momentum indicator" to make this judgment). So, these primarily domestic names have seen PE multiple expansion and appear to be technically ahead of themselves. Not necessarily a "sell", but certainly a "don't buy" in my view.

So, as I look at XLY, I wouldn't be surprised by a 5% retracement or more given the technicals and consistent with the view I shared last week. Rather than selling the whole sector for a trade, I would focus on the four names that I discussed in the prior paragraph. From a longer-term perspective, the recent leadership of the Consumer Discretionary sector seems to reflect reasonable valuations, improving fundamentals and perhaps a preference for domestic exposure. Still, with strong performance relative to other sectors over the past several years, the sector is not likely to continue its leadership. Interestingly, while Large-Cap stocks have now slightly outperformed Small-Caps, the Consumer Discretionary names in the S&P 600 have done even better than the S&P 500 names, rising over 17.1% so far this year and offering the best returns in the index by far (Healthcare is second-best at just 11.4%).

In my Top 20 Model Portfolio, where I don't really manage to sector weightings, I have sold two names since the start of the year and now have no exposure to the sector. In my Sector Selector ETF model, I currently have no direct exposure to XLY, choosing instead to focus sector allocations on Financials (XLF), Energy (XLE), Industrials (XLI) and Technology . The balance of the model is invested outside of the S&P 500. In my Conservative Growth/Balanced model portfolio, I currently have two names and about a market-exposure (near 11%), but I am actually likely to add a name in the coming days.

Source: Is It Time To Take Profits In Consumer Discretionary Stocks?