Consumer discretionary ETFs have been sector leaders as U.S. stocks have raced higher, a fact highlighted by an average 12-month gain of 33.7% for the Consumer Discretionary Select SPDR (NYSEArca: XLY) and the Vanguard Consumer Discretionary ETF (NYSEArca: VCR).

Consumer sentiment ended June near a six-month high and weekly jobless claims reports have retreated to multi-year lows, providing fodder for investors to boost discretionary stocks and ETFs like VCR and XLY. Consumers have also benefited from the Federal Reserve’s loose monetary policies, which have depressed borrowing costs. [Retail ETFs Ring up Gains]

Prior discretionary sector ebullience has also boosted valuations for the group to what levels some view as frothy. That could make the sector primed for a pullback. On Thursday, Bank of America Merrill Lynch cut its rating on the sector, calling it richly valued and overowned.

“Consumer Discretionary is the most broadly overvalued sector relatively to history in our work, trading above its long-term average on relative P/B, P/OCF, and Forward P/E. Most industries within the sector are trading at a premium to history on these metrics, and our work suggests that Discretionary is the most overweighted sector among fund managers. In fact, Discretionary is the sole sector that is a consensus overweight by growth, value and core managers alike,” according to a note from the firm obtained by Barron’s.

Whether or not discretionary ETFs are “overowned” can be debated, but investors have pushed almost $2.5 billion combined into XLY and VCR this year with the bulk of those inflows heading to XLY. XLY has nearly $7 billion in assets and a P/E ratio of 18.8, according to State Street data. By comparison, the Technology Select Sector SPDR (NYSEArca: XLK) has a P/E just below 14.5.

Bank of America Merrill Lynch also sees discretionary stocks as vulnerable to rising interest rates.

“With the rise in interest rates, consumers may be in the early stages of a shift toward saving over spending – especially as inflation has remained benign, removing pressures to spend sooner rather than later…The sector’s earnings are also potentially at risk, with near-record profit margins and an increasing number of companies missing on earnings,” according to the note posted by Barron’s.

A strong dollar could also hamper XLY constituents such as McDonald’s (NYSE: MCD) and Starbucks (NasdaqGM: SBUX) that derive substantial portions of their revenue from international markets. Those stocks are both top-10 holdings in XLY.

Consumer Discretionary Select Sector SPDR

ETF Trends editorial team contributed to this post.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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