Checking in with Morningstar on Sector Rotation

by Wayne Ferbert on April 19th, 2013

We have been spending a lot of time in our portfolio management lately thinking about asset allocation and ETF rotation. And it reminded me that Morningstar usually provides a very un-biased look at the ETF landscape along with some commentary on expectations for forward performance in those sectors.
We looked it over and I was surprised at what I saw.
If you examine the 9 SPDR sector ETFs that make up the S&P500, you find that Morningstar has no 5-star rated ETFs in the group and no 1-star rated ETFs either. Two of them are rated 3-stars out of 5 stars: Utilities and Industrials. Two are rated 2-stars: Financials and Healthcare. The remaining 5 sectors are all rated 4-stars: Energy, Technology, Materials, Consumer Staples, and Consumer Discretionary.
I was surprised by these results. As you know, we have been bullish, in order of preference, on Financials, Energy, and Technology. So, the Energy & Technology calls we like. But we are perplexed by the Financials with a 2-star rating. They have a fair value on the XLF of $19 yet it trades at $18. But the rationale for the 2-stars seems to have a lot to do with macro effects of highly uncertain events like regulation and European debt crisis.
We are more in the camp that these firms can continue to race forward and recover value that was still not recovered from 2008/09 drop – not all of the value but some of it. While the biggest financials have reported earnings this last 10 days and been punished because of comparisons to expectations, the revenue growth in these firms was a solid 5% overall. I think that bodes well for these firms given the challenging environment.
One other thing about these ratings really throws me off: what kind of environment would have both Consumer Discretionary and Consumer Staples both move up together? Both get a 4-star rating. Interestingly, both are trading at a level above what Morningstar assesses as their fair value. Consumer Staples is trading at 10% over its fair value and Discretionary at 1% above fair value.
In a correcting market (which many believe we might be in right now), you would certainly expect the Staples to out-perform the Discretionary ETF. But Staples have performed like a defensive play for the last month as rotation in to that space accounts for much of its out-performance this year.
I would not want to be invested in any consumer focused sector right now given recent market performance and current valuations.
But Morningstar’s ratings provide interesting contrast for how we look at our sector rotation.

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