By Caroline Valetkevitch
NEW YORK (Reuters) - Companies that sell consumer goods, such as electronics, cars and appliances, are leading the U.S. market in earnings and share gains, but high valuations and fund managers' big weightings in the sector pose major investment risks.
Valuations for the S&P consumer discretionary sector <.SPLRCD>, which is the best performing this year, have shot up to a level not seen since the end of 2009, when stocks started to rebound but earnings were still lagging as the recession caused by the financial crisis had just come to an end.
Much of the sector's sales growth is concentrated in a few areas of strength, such as carmakers, as well as companies benefiting from the pickup in home prices and changing media trends - companies such as Ford
Their strength may be masking signs that the sector is vulnerable to a pullback, especially if holiday sales are weak or interest rates climb next year, hurting consumer demand.
Investors have been piling into these stocks in recent years, particularly some of the biggest momentum names, like streaming video company Netflix
The sector is up 34 percent since the end of 2012, or roughly 36 percent including dividends, more than any other S&P sector. By comparison, the broad S&P 500 index <.SPX> is up almost 24 percent for the year.
Some investors may end up paying the price, said Dan Suzuki, equity strategist at Bank of America Merrill Lynch, which in August downgraded the sector to underweight.
"It's expensive and over-owned, and we think some of the fundamentals are going to get less supportive," he said. "The risk/reward is clearly to the downside for the sector."
Among the potential negatives could be a slow holiday period, he said. Retailers already are bracing for tight consumer spending, with data firm ShopperTrak forecasting the slowest holiday sales growth since 2009.
Equity funds are heavily weighted in the sector, according to Lipper data. Of 628 equity funds sampled, 273 were overweight in consumer discretionary stocks relative to the benchmark index, second only to 282 for industrials.
The sector is juicing returns for large-cap growth funds, with Amazon, Priceline
The enthusiasm investors have shown for these stocks has caused valuations to rise. The forward 12-month price-to-earnings ratio for the group is 18.1, the highest since December 2009, and well above 14.7 for the S&P 500 as a whole, according to S&P data. More than two-thirds of the sector's 82 companies have a P/E that exceeds the broader S&P's multiple.
The sector is considered the most overvalued of the S&P 500, based on Thomson Reuters StarMine's intrinsic valuation model, which uses expected growth over the coming decade to model where stocks should trade. Netflix, up 268 percent for the year so far, has a P/E of 92.6.
"It's a sector that has been, not just recently but consistently, one of the better-performing sectors since the end of the recession, and as a consequence, it's difficult to find cheap stocks in that space because the rising tide has lifted all boats," said Mark Luschini, chief investment strategist at Janney Montgomery Scott in Philadelphia, which manages about $58 billion in assets.
POCKETS OF STRENGTH
The sector's gains have come despite lackluster U.S. economic growth, including a weak job market.
Low interest rates have stoked demand for homes and cars, as well as companies connected to those areas, such as appliance makers like Whirlpool
"There has been some pent-up demand in areas like autos, but I think a lot of that at this point is baked into the stock prices," Suzuki said.
While interest rates are expected to remain low for the time being, the Federal Reserve could begin scaling back its stimulus as early as December, although it is more likely to start doing so in the first quarter of next year.
Also helping the sector: Consumers have embraced technology that provides new ways of delivering entertainment and communication - such as Amazon.com, Netflix and Comcast. Internet retail companies lead projected earnings growth for the third quarter, with an estimated gain of 74 percent.
That's why the bulk of the sector's 10 percent estimated growth for the third quarter - excluding results for homebuilder Pulte Group
Minus those three, the sector's earnings growth is seen at 6.5 percent, Thomson Reuters data show. Year-over-year profit growth for the S&P 500 is seen at 4.2 percent.
Consumer discretionary stocks' sales growth is estimated at 5.8 percent, but it would be 4.5 percent without Ford, Amazon.com and General Motors
Still, in parts of the retail space, the picture looks shaky. Both luxury goods maker Coach
Results for the third quarter are in for 46 of the 83 S&P 500 consumer discretionary names. Most retailers - which make up more than 30 percent of the sector - are due to report later this month. Some have expressed concern about the holiday season, which typically accounts for the bulk of most retailers' annual revenue.
Some analysts say the holiday season will be the most heavily discounted in years as stores try to lure in budget-conscious consumers. Department stores are the weakest sub-sector of the group, with an estimated $70 million loss for the third quarter mostly because of a $533 million projected loss for J.C. Penney
(Reporting by Caroline Valetkevitch; Editing by Nick Zieminski)