Falling in Love...Again

2015 has been a hard year to call one way or the other as the only consistent trend among domestic equities has been steady outperformance by consumer discretionary stocks (thank you Amazon) and more of the same from the energy sector.  While one month does not a trend make, there was a distinct shift last month that could show investors are falling in love again with some of their old favorites.

July was a major month for the classic defensive equity plays as both utilities and consumer staples managed to deliver solid outperformance against the broader market after a challenging start to 2015. “Less Bad” was all it really would have taken to capture the attention of investors after the wild ride that markets took in July but both sectors managed to turn heads by delivering positive returns instead of just “less negative” performance. Utilities were the stand out performer among the different sectors with a 6.1% return for the Utilities Select Sector SPDR Funds’ (XLU) compared to a more modest 1.9% gain for the S&P 500 which is still small compensation to those investors who held the fund through the first half of the year when it delivered an uninspiring loss of 10.7% after a 28.7% gain in 2014 that outperformed the S&P 500 by 1500 bps.  That solid outperformance helped the fund add over $1.7 billion in new assets in 2014 but easy come, easy go and $1 billion flowed right out of the fund again in the first half of the year. But thanks to a major shift in momentum in late June, the fund started the third quarter off on the right foot with a solid $360 million inflow for the month of July.

The pain felt by XLU at being left to dance all alone was nothing compared to the Consumer Staples Select SPDR Fund (XLP) which enjoyed a much more modest 2014 where it solidly outperformed the S&P 500 by 200 bps and pulled in another $2.3 billion in new assets.  While the fund had a much better first half compared to XLU with a loss of only .62%, investors looking to make up missed performance all rushed to financials and tech stocks in unison and took over $2.6 billion of XLP’s assets with them in the process and leaving the fund a net asset loser in the process.  But like XLU, XLP steadily picked up momentum against the other sectors of the S&P 500 as it found its legs on June 16th with the consumer staples bell weather outperforming the broader market to the end of July by 141 bps.  That momentum improvement helped stopped the bleeding after a difficult five months; XLP saw $330 million leave the fund in May but only $70 million left in June and with the funds changing fortunes investors are finding something to love about one of the markets homelier sisters with over $530 million in new assets in July or about an 8% increase in one month!

That strong focus on shifting from offense to defense has pushed up XLU and XLP’s ETFG Behavioral Quant Scores with both funds surging up our lists with XLP now ranking ahead of former darling Health Care Select SPDR (XLV) while XLU could soon surpass XLV if the price momentum continues to pick up speed.  And while some buyers may be hoping for strength in numbers (specifically a higher dividend yield than SPY), three numbers they should be keeping an eye on are a little troubling to the value-oriented investors.  XLU and XLP have a lot in common beyond their tickers, sponsors and usual customers; both funds have relatively concentrated portfolios; XLU has 29 holdings and 60% in the top ten while XLP is relatively more diverse with 37 positions but over 63% in the top ten with one stock, Proctor & Gamble (PG) taking up over 11% of the portfolio and whose weak performance last week only slightly dragged on returns thanks to strong returns from Mondelez and Reynolds American.  The other two numbers to watch are valuations as XLP now trades at a significant premium to the broader market with a trailing P/E ratio of 20.64 to SPY’s 18.62 and an even more significant P/B premium of 4.5X compared to SPY’s 2.6X.  XLU would be the cheaper date with a trailing P/E ratio of 17.06 and P/B of 1.68 but price isn’t everything as even that lower than market P/E ratio is still in the top 5 percentile of where the fund has historically traded.

The one question left unanswered is where is the money coming from?  After all, if investors had rekindled their love affair with the defensive favorites, who else must be getting the cold shoulder?

Some Advisors are taking the view that the best protection against the coming rate hikes is to flee bonds all together, but on the whole the credit sector is seeing more rotation than panic selling as the iShares 1-3 Year Treasury Bond ETF (SHY) and iShares iBoxx $ High Yield Corporate Bond ETF (HYG) made our short list for largest inflows last month while the other side of the ledger showed a $650 million outflow from the Vanguard Total Bond fund (BND) as investors find more novel ways to reduce duration.

A more likely funding source was emerging market stocks where investors continued to take more chips off the table while they wait for the fall-out from the FOMC’s interest rate jawboning to stop. The iShares MSCI Emerging Markets ETF (EEM) saw a nearly 10% outflow in July and bringing the fund’s net asset loss in 2015 to nearly $6 billion or close to 20% of its assets at the start of the year. Foreign stocks may have supplied some of the capital, but small outflows from the technology sector helped the cause as the Technology Select Sector SPDR Fund (XLK) made our list of top outflows thanks to a loss $480 million or close to 3.5% of assets.  While XLK outperformed the broader S&P 500 last month, it’s year-to-date performance has been more uneven with the fund being lapped by SPY in 3 of the last 7 months leaving investors with a mere 50 bps of outperformance for their troubles.  With the markets being buffeted be concerns over the FOMC and more volatility out of China, tech stocks definitely don’t ignite the same passions they did in 2014.

Thank you for reading ETF Global Perspectives!


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