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XLI: Stuck In A Tight Range With Risks Tilted To The Downside

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About: Industrial Select Sector SPDR ETF (XLI)
by: BOOX Research
Summary

XLI has traded in a relatively tight trading range since reaching its all-time high back in January of 2018.

Economic indicators such as industrial production and ISM manufacturing index point to weaker conditions for industrial sector even as stocks remains supported based on steady earnings growth.

Performance and valuation metrics of underlying firms presented with our view on where the ETF is headed next.

Industrial Select Sector SPDR ETF (NYSE:XLI) tracks the performance of the sector constituents within the S&P 500 (SPY). In contrast to the more visible and widely followed Dow Jones Industrial Average Index (DIA), which includes many companies outside the traditional sense of "industrials", XLI closely aligns to its name including the most important stocks in industries from aerospace and defense, industrial conglomerates, transportation, airlines, machinery, road and rail, logistics, and construction. We like this fund because of its wide diversification including 69 companies that are representative of both the trends in the sector and underlying economic conditions. In the context of the ongoing bull market this decade, XLI has outperformed the S&P 500 although we note that it peaked back in January of 2018 and has traded in a relatively tight range since. This article looks at the recent performance of the underlying stocks and our view on where XLI is headed next.

(source: FinViz.com)

Macro Backdrop

The decade since the financial crisis has been particularly strong for the market from the lows of asset prices that year. XLI is up 252% over the past 10 years on a total return basis, outperforming SPY which has returned 236% and DIA u 243%. Indeed, steady economic growth, strong earnings, and favorable global trends for many of these multinational corporations have presented an overall positive operating environment leading to impressive financial results and equity returns.

On the other hand, XLI peaked back in January 2018 briefly trading above $80.00 per share while SPY and DIA went on to make new highs including setting its latest record this past July. By this measure, XLI has been effectively "stuck" for the past 21 months including a period of extreme volatility in Q4 last year. XLI is currently down 8% from its all-time high.

Chart Data by YCharts

One of the major themes going back to last year has been the ongoing U.S.-China trade dispute which has led to rising uncertainty among global trade dynamics and business confidence in the U.S. In 2018, a trend higher in interest rates including a rate hike by the FED led to increasing levels of concerns over the impact to the economy as growth expectations pulled back. This year, a more dovish policy stance by the FED and better than expected earnings has largely supported the market but industrial production including manufacturing and trade dynamics continue to be the weaker component of the overall macro outlook. The growth rate of industrial production index has trended lower over the past year with the latest reading for August 2019 showing an increase of just 0.4% compared to the period last year.

(source: Trading Economics)

One of the major indicators pointing to the overall weakness in the industrial sector is the U.S. manufacturing purchasing managers index 'ISM manufacturing index' which is a survey among manufacturing firms and seen as a snapshot of business confidence and sector sentiment. The index here for September fell to 47.8 with a reading below 50 signaling a contraction. This was the weakest reading for the index going back to June of 2009.

(source: CNBC)

While the constituents of XLI are a diverse group and not necessarily directly exposed to trends in industrial production or manufacturing, the point is that it highlights the broader sentiment for underlying macro conditions. The dynamic today is one of softer economic data while there is an expectation that recent interest rate cuts by the FED will lead to a renaissance of growth going forward. We are less optimistic and see risks as tilted to the downside.

XLI Performance

The table below presents the performance metrics for all 69 XLI constituents highlighting the year to date return. These are total returns including the dividend and what an investor would likely have achieved over these holding periods. Year to date, XLI is up 17.7% and we note the percentage gains are in the context of the extreme levels of volatility observed in Q4 last year.

It's been an overall positive year for many of the top holdings and mega-cap names in the group. We highlight Aerospace and Defense stocks including Lockheed Martin Corp (LMT), Northrop Grumman Corp (NOC), and L3Harris Technologies Inc (LHX) as among the top performers up 49.4%, 52.1%, and 54.6% year to date each respectively.

3M Company (MMM) with a 3.94% weighting int the fund is a notable decliner, down 17.4% this year. The weakness for MMM this year goes back to a big miss in its Q1 earnings result where management noted slowing conditions and cut full year guidance. The top holding in the fund Boeing Co (BA) is a curious case as it's up 18% this year largely shaking off the repercussions from the ongoing 737 Max imbroglio which has grounded the worldwide fleet following the devastating Ethiopian Airlines crash back in March.

XLI holdings performance metrics. source: data by YCharts /table author

Copart Inc (CPRT) a provider of online car auctions and vehicle marketing services for the insurance industry and commercial users is the best performer in the fund, up an impressive 66.9% year to date. Coming off a deep pullback in Q4 of last year, the company in 2019 has reported a string of better than expected earnings with increasing financial margins. Cintas Corp (CTAS), which specializes in workplace uniforms and facilities maintenance is also a strong performer up 55.3% in 2019. Among the losing stocks in XLI this year, American Airlines Group (AAL) down 18.8% is the worst performer. Overall, trends in earnings and company specific factors describe the performance of the big winners and losers.

Stock Industry Weight in XLI Market Cap $bn Price YTD % Return
Copart Inc (CPRT) Auto & Truck Dealerships 0.72% 18.524 $79.76 66.9%
TransDigm Group Inc (TDG) Aerospace & Defense 1.14% 27.457 $514.42 60.1%
Cintas Corp (CTAS) Business Services 0.97% 27.357 $260.97 55.3%
L3Harris Technologies Inc (LHX) Aerospace & Defense 2.05% 45.799 $205.77 54.6%
Jacobs Engineering Group Inc (JEC) Engineering & Construction 0.54% 12.046 $88.90 53.4%

Top 5 Winners XLI YTD 2019. data by YCharts

XLI Analysis and Forward-Looking Commentary

We think it's a delicate time in the market and see the industrial sector and XLI itself as an important indicator for the overall health of the market as it relates to sentiment. One of the metrics we're looking at in terms of valuation is the sector P/E ratio on a forward basis which we calculate at 16.6x as a median between the 69 stocks as all-in-all reasonable. Note that the fund manager State Street lists a forward P/E ratio of 17.4x. Outside of Boeing which as mentioned is facing unique challenges this year, the top 20 holdings do not appear to present overly stretched or aggressive valuation multiples. The case is simply of still positive earnings growth expectations and recurring free cash flow.

XLI holdings valuation metrics. source: data by YCharts /table author

The dividend yield for XLI currently at 2.11% is above the 5- and 10- year average suggesting the fund is relatively inexpensive with a compelling income component. XLI's dividend yield also 22 basis points higher than SPY, which is the widest level in recent years. By this measure investors could see value in the ETF although it's not convincing enough for us to initiate a long position based just on this one metric.

Chart Data by YCharts

Takeaway

We think XLI is a solid exchange traded fund and a good option for investors to own a diversified collection of quality companies that are often times leaders in their respective industries. With that said, we rate XLI as a hold balancing what appears to be relatively reasonable valuation metrics for the underlying firms with a more bearish opinion of global macro conditions.

A breakout above $80 for XLI, or similarly a breakdown under $70 per share, are the key levels we see that will confirm the next trend in direction. Investors should monitor ongoing developments in the U.S-China trade dispute and upcoming 2020 U.S. Presidential elections as the major themes for the year ahead. A deterioration in the economic outlook would likely lead to revisions lower ion earnings estimates and open the door for more extended downside. Take a look at the fund's prospectus for a full list of risk and disclosures.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.