Last week, the S&P 500 decisively broke out to a new, all-time high, crossing the 4,000 level on strong volume. This followed a multi-month consolidation period that saw inflows into cyclical and value stocks, while frothier and more speculative parts of the market saw deep corrections.
The primary catalyst for this market action was the rise in long-term rates and an increase in growth expectations. Over the last two months, the 10Y Treasury has risen from 1% to 1.7%. Higher rates and accelerating economic growth make high-multiple and speculative stocks less attractive, while these conditions boost the profitability of value and cyclical stocks.
Looking ahead, I believe the rally in the market will continue, with all the major indexes participating in the advance (unlike the last two months). Three ETFs that investors should consider buying are the iShares Russell 2000 ETF (IWM), Health Care Select Sector SPDR Fund (XLV), and the Invesco QQQ Trust (QQQ).
Before we analyze these ETFs, let’s take a step back to evaluate the current economic conditions.
Regarding market conditions, I believe that the correction in “frothy” stocks and rotation into value stocks was a healthy development for the bull market’s longevity. Many traders and funds who were deploying excess leverage were punished, while prudent investors have an opportunity to add exposure to stocks at lower prices.
At the same time, the economic outlook continues to improve. According to the CDC, about 31% of Americans have received their first dose, while 17% are fully vaccinated. Additionally, data shows the vaccines are effective in terms of minimizing asymptomatic spread, and early clinical trials are showing it working in children with minimal adverse effects. These developments increase the odds that the economy should be able to return to normal by the end of the year.
The labor market is another bright spot. According to Indeed.com, job listings are now above pre-Covid levels (adjusted for website traffic). Of course, this was validated by the March jobs report which showed an addition of 916,000 and another 150,000 jobs in previous months due to positive revisions.
This week, the latest US Consumer Confidence report also reached a one-year high with a record number of participants indicating that they plan to buy a home. TSA travel data also continues to rebound and shows the number of travelers at 60% of 2019 levels. This is also confirmed by reports from Delta Airlines (DAL) and Disney (DIS) reporting strong demand for summer travel.
Now, let’s look at three ETFs that investors should consider buying given this constructive market and economic outlook:
iShares Russell 2000 ETF (IWM)
IWM is about 4.5% off its all-time high from mid-March. However, the group has been a major outperformer YTD with a 13.5% gain which compares favorably to the S&P 500’s 7.5% gain.
I believe this outperformance will continue as small-cap stocks tend to be more sensitive to economic conditions.
In recent months, analysts have been hiking their expectations for second-half GDP. Another contributing factor is that IWM has a higher concentration of financial and cyclical stocks which also tend to rise with increasing rates and inflationary pressures.
Despite favorable macro conditions and impressive YTD gains, IWM remains reasonably valued with a price to earnings (PE) ratio of 20.5. In contrast, the S&P 500 has a PE ratio of 29. Previous bull markets have topped with a PE ratio for the IWM in the 35 to 40 range. Thus, IWM has the potential for more gains due to earnings growth and multiple expansion in the coming months.
The POWR Ratings are quite bullish on IWM, as it’s rated an A which equates to a Strong Buy. A-rated stocks outperform the market averages by a significant degree. This is consistent with the performance of small caps during periods of accelerating economic growth.
The POWR Ratings also evaluates ETFs by component grades including Trade, Buy & Hold, Peer, and Category. To see more, click here.
Invesco QQQ Trust (QQQ)
QQQ had been the leading major index during the previous bull market from 2009 to 2020, and it was the leader during the initial months of the recovery that started in March 2020.
When looking at the QQQ, the most important aspect is the mega-cap tech stocks such as Amazon (AMZN), Apple (AAPL), Facebook (FB), and Google (GOOGL) which comprise a large weight in this portfolio. These stocks have been mostly range-bound since the summer, however, they have continued to deliver strong earnings reports, leading to attractive valuations particularly from a PEG perspective.
Semiconductors are another important indication as they tend to be forward indicators of tech demand and spending. This sector is quite strong as well with a handful of names breaking out to new highs this week amid a supply crunch and strong demand.
Many of the newer, emerging technologies like AI, machine learning, VR, and autonomous vehicles will lead to even higher demand in the coming years. Thus, many analysts believe that semiconductors will remain in a secular uptrend over the next demand and remain disconnected from the economic cycle.
This combination of strength in semiconductors and a healthy consolidation in mega-cap tech stocks, while earnings continue to compound, underpin the bull thesis for QQQ.
QQQ is rated a Strong Buy according to the POWR Ratings. This isn’t surprising given the high-quality companies in the market that are above average in terms of growth and value. To see more about QQQ’s component grades, click here.
Health Care Select Sector SPDR Fund (XLV)
Ben Franklin famously said that the only certainties in life are death and taxes. Well, we can now add increasing healthcare spending to that list. Over the last 50 years in the US, healthcare spending has increased from $75 billion to $3.3 trillion. As a share of GDP, it’s grown from 6.9% to 17% of GDP.
We are seeing similar trends in developed countries all over the world, and costs are also starting to rise in developing countries as well. The major factors are that the population is getting older, constant innovation in new treatments, and inelastic supply.
Of course, another contributing factor is that healthcare is subsidized by the government in many parts of the world, and these areas also tend to see costs rise faster than other parts of the economy such as education and defense.
For investors, it means that they should have exposure to the healthcare sector especially since these trends are not going to subside anytime soon. XLV is a low-cost, well-diversified ETF with holdings of insurance, pharmaceutical, and medical device companies.
XLV is rated a Strong Buy according to the POWR Ratings. XLV also has As across the board for its component grades including Trade, Buy & Hold, Peer and Category.
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QQQ shares rose $0.35 (+0.11%) in after-hours trading Monday. Year-to-date, QQQ has gained 5.65%, versus a 9.04% rise in the benchmark S&P 500 index during the same period.
About the Author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of POWR Growth newsletter. Learn more about Jaimini’s background, along with links to his most recent articles. More...
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