Which Sector ETFs Are Cheap?

Sector rotation strategies have long been popular with investors–especially those who believe they are able to spot relative opportunities in various corners of the market. Sector rotation strategies have the potential to�generate significant alpha, as there are often big differences between performance of various sectors of the economy. Timing movements into strong performers and out of laggards can be a way to generate excess returns relative to a broad-based benchmark.

Though many investors assume that all corners of the market generally move in unison, the reality is quite different. So far in 2012, the Consumer Discretionary SPDR (XLY) has added about 12%. The Energy SPDR (XLE) is down about 4%–a significant gap between two ETFs that both offer exposure to large cap U.S. stocks [sign up for the free ETFdb newsletter].�

Sector ETF PEGs

For investors looking to determine relative opportunities in sectors of the U.S. economy, examining the PEG ratios of the various sector-specific products can be an interesting exercise. PEG ratios, which are calculated by dividing P/E multiples by expected earnings growth rates, take into account both the price of an ETF relative to the underlying stream of earnings as well as the expected growth in earnings of component companies. It’s a quick way to measure how much you’re paying for future earnings, which is considerably more useful than a pure backward-looking approach. Assets with higher expected earnings growth are generally more expensive than those with low growth prospects, and vice versa.

[See 101 ETF Lessons Every Investor Should Learn]�

There are, of course, limitations to using such a metric. For starters, analyst estimates are involved, and we’ve learned that there is considerable room for error when forecasting earnings. Below are the PEG ratios for all nine sector SPDRs, as well as for the broad-based SPY (data as of 5/25/2012):�

Ticker	Sector	Forward P/E	3-5 Year EPS Growth	PEG
XLK	Technology	12.60x	13.32%	0.95
XLY	Discretionary	15.43x	15.43%	1.00
XLP	Staples	15.77x	8.76%	1.80
XLU	Utilities	14.73x	3.87%	3.80
XLV	Health Care	12.24x	9.13%	1.34
XLI	Industrials	12.65x	12.52%	1.01
XLF	Financials	11.02x	10.59%	1.04
XLB	Materials	12.37x	10.70%	1.16
XLE	Energy	10.22x	9.78%	1.04
SPY	Broad Market	12.53x	11.08%	1.13

Reading The Tea Leaves

Analyzing the PEG ratios above shows some interesting results. Technology stocks seem to be cheap now; XLK’s forward P/E is only slightly higher than the broad market, despite expectations for considerably higher earnings growth. And it certainly appears as if there is a bubble forming in the utilities sector. As markets have tumbled lately, investors have flocked towards the corner of the market known as a relative safe haven and source of attractive and stable dividend yields. As a result utilities stocks are among the most expensive in the current environment, despite offering the least promising growth potential. If stocks are able to bounce back in coming weeks, a long XLK / short XLU trade could have considerable upside [see the High Tech ETFdb Portfolio].�

Consumer discretionary stocks also look appealing with a PEG ratio of about 1x, though it should be noted that this sector has the highest expected earnings growth. If this sector isn’t able to follow through on expectations for annual growth of about 15% in earnings, it could have trouble maintaining such a lofty valuation. �