Equity Sector Update: Upgrade Retail

Summary

• We upgrade the retail sector (XRT) from underweight to market-weight.
• We add two ETFs to the energy sector – XOM (covers exploration and production companies) and OIH (oil services companies) – as overweights.
• We downgrade Materials (XLB) from overweight to underweight.
• We stand by our overweight recommendation on homebuilders even though conventional wisdom says they are about to get crushed. Unlike previous cycles, housing is unbuilt, not overbuilt, as rates rise. Homebuilders can keep making money even as housing slows.

Retail

We initially recommended an underweight in the retail ETF (XRT) on June 10, 2021. Since then, it has underperformed the S&P 500 (SPX) by 32%. Retail rallied massively for the first year of the pandemic as consumers turned to goods. At this point valuation metrics have returned to near pre-pandemic levels and the price is near the pre-pandemic trendline.

Retail will likely go through ups and downs as consumers respond to inflation and the possible approach of a recession, but we expect its performance to be more in line with the broader market going forward.

Energy

We bolster our Energy sector overweight with two subsector recommendations. XOP ETF covers exploration and production companies in the oil and gas industry. They will be primary beneficiaries of high energy prices and the sharp industry turn to prioritizing free cash flow over boundless CAPEX.

OIH ETF, which covers oil service companies, might seem odd; how do they benefit if E&P companies are turning away from free-spending CAPEX? Oil service companies bring technology and efficiencies to the table; they can help E&P companies get more out of their CAPEX dollars

Materials

The materials sector (XLB) has outperformed the SPX by 1.5% since we recommended an overweight on 14 April 2022. We are shifting to a tactical underweight largely because of weakness in industrial metals commodities due to the China Covid lockdowns, and the prospect of a slowing economy as the Fed raises rates to fight inflation.

Homebuilders

We have received pushback from investors on our overweight recommendation on homebuilders (XRT). And the market has pushed back hard – since we initiated this position on May 28, 2021, it has underperformed the SPX by 14.5%.

The market continues to view homebuilders through past conventional wisdom. That is, during good time homebuilders overbuild, then when rates rise housing slows, and homebuilders get crushed. That certainly happened during the aughts. The mania was such that by 2007 housing supply had gotten a year or more ahead of organic demand. It took years to work off that excess supply.

Flash forward 15 years. A shrunken industry doesn’t have the capacity to keep up with organic demand – i.e., demand due to population growth and maturing millennials. Housing supply is now about a year behind organic demand. If demand simply ceased to grow it would take a year just to catch up. Instead organic demand is growing at roughly the pace that builders can build new housing – forget catching up.

Look no further than the National Association of Homebuilders builder sentiment index (USHBMIDX Index on Bloomberg), one of the more manic/depressive economic indices out there. It is at 77 – down from 85 a few months ago – but still higher than any previous housing boom despite the threat of rising rates.

The short of it is, barring outright economic collapse or major crisis, homebuilders can keep building and making money.

We stand by our overweight recommendation.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.